Wednesday, May 16, 2012

A Financial Thriller?

Review of Robert Harris, The Fear Index. New York: Alfred A. Knopf, 2012

Several months ago, some members our family were settling down for a Friday movie night and a guest asked what we were going to watch.

"Margin Call," I said.

"What's that about?" our guest asked.

"It's a financial thriller."

"What's a financial thriller?" said the guest.

That was a great question. It's not exactly a familiar film or novelistic genre.

But the recent global financial crisis has spawned a few engaging stories, both fictional and journalistic, that also educate us a bit on the world of high finance (many of them reviewed in this space).

For a recent case in point, consider English novelist Robert Harris' most recent book. The Fear Index tells the story of Alexander Hoffman, an American physicist turned hedge fund trader, whose life is completely upended when a computerized algorithm invented by Hoffmann starts acting autonomously. This algorithm, called VIXAL, threatens to take over Hoffman's life and business. It all comes to a head in a crazy twenty-four period that begins when Hoffmann receives a rare first-edition copy of a book by Charles Darwin in the mail from an anonymous source.

Although the plot is "wholly implausible," as the Economist reviewer put it, the novel weaves together three main questions into a truly page-turning and engaging read. First, a classic science fiction strand: what would happen if machines, which dominate our lives, start taking autonomous action? Second, an interesting thought experiment: what if those machines followed Darwinian logic and sought to dominate the world? (It's significant that quotations from Darwin's works head nearly every chapter.) Third, a straightforward teaching function: what are hedge funds and how do they work?

It's this last point that interests me the most here. The Economist, which knows these things, says that "as a guide to what hedge funds actually do, [the book] is surprisingly clear and instructive." 

Two passages in the book illustrate this teaching function. First, in a few colorful (and creepy) sentences, Harris manages to explain hedging strategies of traders in a way that makes sense. Alexander Hoffmann, the main character, has just met an English financier who wants to recruit him to start a hedge fund. Hoffman asks, "What's a hedge fund?"

The English financier tells him to look across the room at a woman. He says that he is absolutely convinced that she is wearing black underwear, and he wants to bet a million dollars that he is right.
The trouble is, if I’m wrong, I’m wiped out. So I also bet she’s wearing knickers that aren’t black but are any one of a whole basket of colours—let’s say I put nine hundred and fifty thousand dollars on that possibility: that’s the rest of the market; that’s the hedge. . . . Now, if I’m right, I make fifty K, but even I’m wrong I’m only going to lose fifty K, because I’m hedged. And because ninety-five percent of my million dollars is not in use—I’m never going to be called on to show it: the only risk is in the spread—I can make similar bets with other people. Or I can bet on something else entirely. And the beauty of it is I don’t have to be right all the time—if I can just get the colour of her underwear right fifty-five percent of the time I’m going to wind up very rich. (p. 177)
That's what hedge funds do. They leverage their money across multiple risky bets, while hedging those risks to try to limit the damages if their bets about the future are wrong. And they may be speculating over very intimate details of our lives. (The creepiness of speculating on the color of a woman's underwear is essential to the character that Harris is sketching here. He's not condoning it so much as trying to depict how a real hedge fund trader would talk.)

The second example comes late in the book, when the VIXAL program appears to be running out of control:
That VIXAL was purely mechanical and possessed no emotion or conscience; that it had no purpose other than the self-interested pursuit of survival through the accumulation of money; that it would, if left to itself, in accordance with Darwinian logic, seek to expand until it dominated the entire earth—this did not detract for Hoffmann from the stunning fact of its existence. He even forgave it for the ordeal it had subjected him to: after all, that had purely been for the purposes of research. One could no more pass moral judgment on it than one could on a shark. It was simply behaving like a hedge fund. (pp. 262-63)
"It was simply behaving like a hedge fund." And how does a hedge fund behave? Like the machine, it has "no purpose other than the self-interested pursuit of survival through the accumulation of money."

Most ordinary people have no idea that the hedge fund world even exists. But the recent news about J.P. Morgan's two billion dollar loss in a risky hedging trade reminds us that overly aggressive risk-taking can be disastrous for banks and the ordinary people who use them.

Still, despite the crucial importance of risk-taking in the global financial system, "financial thrillers" will always attract a small audience. Our guest stayed to watch Margin Call, but fell fast asleep halfway through. 

No comments:

Post a Comment