Wednesday, July 4, 2012

Did Mathematics Cause the Financial Crisis?

Owing to the complex nature and the many loopholes inherent in risk assessment formulae, mathematics is largely to blame for the financial crisis that shook the world in September 2008 and wiped tens of billions off the value of companies.By extension, countries renowned for mathematics, and France is a prominent candidate, are among the guilty parties, indicted for supporting potentially pathogenic explanations with scientific guarantees. Finance needed high-flying mathematical wizards and went looking for them in their natural habitat, France included, a country also known for its thriving banking and financial culture. The global press from Wall Street Journal to Le Monde or the online magazine Wired collectively flew into a rage over global maths. Le Monde accused French engineers with French-style education and training of pushing American finance into an abyss and, with it, global financial markets. How did this happen? By proposing mathematical models to the heads of financial institutions that claimed to counteract the risks inherent in financial products, but which ultimately failed to live up to their promises.

Mathematicians plead not guilty
Michel Crouhy, director of R&D at the French bank Natixis, an institution that was badly affected by the sub-prime mortgage crisis, and the founder of the first master’s course in mathematical finance in 1986, refutes this criticism outright. “The models worked perfectly well, even during the heart of the 2008 crisis. Each morning they predicted the amount that we would be losing during the day with great accuracy. The main issue here does not concern models, but has to do with the drying up of liquid assets, so there was no compensation whatsoever for our positions. Without liquidity, the market is bound to plummet whatever the model.”

Banks generally cover their risks because they are constantly involved in mark to market dealings; they know what their assets are worth and verify that what they pay for their protection is a sustainable price. If the covering price soars, the positions come down. In addition, banks make “model risk” provisions by holding in reserve a part of the profits contributed by the activity of these models in reserve. In the end, they make compromises between the precision of the models and the duration (and therefore the cost) of the calculation.Every banker knows there are no profits without risk. And mathematicians know very well that 100% coverage of risk is a myth. Bernard Lapeyre, mathematics professor at the Ecole Ponts ParisTech (ParisTech School of Civil Engineering), sums this up. “The incompleteness of markets disallows perfect replication (coverage). There will always be a residual risk.”

In the beginning of this century when the market moved from the share derivatives and rate derivatives of the 1980s to credit derivatives, we reached a stage where risk coverage was no longer, even theoretically possible. What we have seen in the late 2000s was in fact a direct result of the 1990s innovation of credit derivatives. Credit derivatives are securitized derivatives whose value is derived from the credit risk associated with the underlying loan, deal or debt. The aim of credit derivatives is to transfer the risks (and part of the revenue!) associated with the credit through “securitization” without transferring the asset itself.

Michel Crouhy

Risky formulas
Up to mid-2007, credit derivatives (collateralized debt obligations (CDOs) and credit default swaps (CDSs)) were traded on the basis of the Gaussian copula, a formula devised by Chinese mathematician David X. Li. Li was born in the Chinese countryside in the 1960s, went to the University of Nankai (Tianjin), where he earned a masters, and then to the University of Ontario where he did a PhD in statistics. It was in 2000, while working for J. P. Morgan Chase that he created his equation. The formula measures the correlation between the default probabilities of two borrowers on the sole basis of the history of credit derivative prices, ignoring the history of the defaults themselves.There is something outrageously simplistic about Li’s formula (as is elegantly put in Wired magazine) and perhaps because of this it achieved spectacular success and was widely adopted. It made pricing risk seem easy, but in so doing it gave a deceiving sense of certainty of the real value of the underlying assets, which for the most part was real estate.

Because of this, can Li be held accountable for the bursting of the sub-prime mortgage bubble? Natixis’ Michel Crouhy does not think so. “This type of equation was useful for discussions among us (mathematician bankers) about the market. But to assess their own risk, banks used much more comprehensive models.” He has absolutely no doubts whatsoever where the blame lies. “Those responsible for the crash are the political and financial leaders who, for years on end, encouraged banks to make loans to insolvent borrowers, the sadly notorious Ninja (no income, no job, no asset) loans. Rating agencies also took part in the grand patch-up exercise. In 2006-2007, they took part in the structuring and rating of sub-prime CDOs using inaccurate information on securitized mortgages and inaccurate statistics. In a clear breach of ethics, Moody’s got half of its profits by distributing CDOs to which it had just assigned the AAA top rating. As for the regulators, they did little to stop the massive fraud in the distribution of sub-prime loans even when problems first came to light as far back as 2005.”No one wanted to see the storm coming. After two decades of expansion during which few borrowers on the American real-estate market defaulted (or if they did it was for specific, individual reasons), no one seems to have predicted that if the market went into decline, the subsequent numbers of defaulters would throw the Li equation off course. It would be similar to the crash of 1987, which highlighted the weaknesses of the Black-Scholes equation in pricing options.

Theories and practices
In the case against mathematics and mathematicians, there is one accused party who stands out: Nicole El Karoui and Marc Yor, both professor of applied mathematics and the persons in charge of the masters program in probabilities and finance at the Paris VI university and a research fellow at Ecole Polytechnique. Many of the graduates from Nicole masters program, or “quants” (quantitative analysts) ended up at in the top ranks of banks like Goldman Sachs, Lehman Brothers, BNP Paribas and Société Générale, as well as in rating agencies and hedge funds. Karoui puts the role of maths into perspective. “Maths is just a simple tool in decision making, just like computers. Each person must take his or her responsibility seriously. If you observe bank sociology carefully, you will see that mathematicians are not the ones who make decisions. All of us warned that the risk factor linked to credit derivatives (CDOs and CDSs) would increase in a non-linear fashion depending on the quantity of operations, but who listened to us? Faced with greed, it wasn’t the models that were lacking, but pragmatism and common sense.”

Nicole El Karoui

At a certain stage, even common sense would have served no purpose. Andrew Lo, head of the financial engineering department at the Massachusetts Institute of Technology (MIT) explains: “Imagine it is 2005 and you are the risk manager at Lehman Brothers, and you know that the real estate market is going to burst and that your bank is in grave danger because of its exposure to sub-prime mortgages. If you advise the chairman, Dick Fuld, to withdraw from the sub-prime mortgage market, he will ignore your advice as he will not be willing to jeopardize traders’ bonuses and to trigger an exodus of his best people. And even if you were commissioned, theoretically speaking, to cover the bank against its questionable mortgage-backed products, you would have lost huge sums in 2005 and 2006 and the first six months of 2007. But you would already have been sacked long before that.”

Most of the time, pro Math arguments smack of false modesty and, in effect, hide behind technicalities. The models are, to borrow Nicole el Karoui’s definition, “simple reductions of the reality, which work under certain hypotheses and are derailed in volatile situations.” The anti-maths crowd claims that pure mathematicians are motivated only by the aesthetics of their solutions. They sacrifice pragmatism to elegant formulae and end up confusing reality with the models. In short, according to them, models are neutral and fragile and therefore blameless.The accusers claim that mathematicians injected to the financial markets the destructive illusion that risk is a known, measured and containable factor. When all traders, trained in the same theories, seek refuge behind the same simplistic equations, so as to maximize their employers’ profits and their own bonuses, no one wants to remember that free and efficient markets can sometimes be struck by sheer madness and come to a grinding halt. The herd instinct wreaks havoc and the sweet theory of rational agents generates irrational behavioral patterns through a widespread unwillingness of anyone to be held accountable. Furthermore the excessive technicality of the models leads to a de-linking between the decision makers and financial engineers within banks because they lack a common language. De facto, this inability to communicate cancels out any possibility of arbitrage, and favors unexpected crashes.

In the eyes of Jean-Philippe Bouchaud, professor of physics at Ecole Polytechnique, given its theoretical leanings, the French school of mathematics, “is an integral part of the systemic risks” which threaten global finance. The models, adds Claude Bébéar, founder of the French insurer AXA, “are intrinsically incapable of taking major market factors into account, such as psychology, sensitivity, passion, enthusiasm, collective fears, panic, etc. One must understand that finance is not logic.” Bouchaud further suggests replacing financial mathematics by another approach. “Over a span of 20 years, tremendous changes have taken place. Computers and their storage capacity enable us to handle colossal amounts of data and thereby compare reality with theory. Experimentation must replace what might appear to be axiomatic in finance. The investigative methods used in physics, those used in fluid mechanics for instance, are better adapted to this work as they verify the plausibility of the results obtained at each point in time. “ In effect, one must start with reality, and be distrustful of pre-suppositions.
Jean-Philippe Bouchaud

Financial mathematicians are also accused in certain circles of having blindly followed “Brownian” ideology and these arguments are set out in a recently published book, Virus B: Financial crisis and mathematics , by Christian Walter and Michel de Pracontal, This ideology holds that financial phenomena, such as share price fluctuations, obey Brownian laws of motion, a theory put forward by the British botanist Robert Brown (1773-1858) when he studied the behavior of pollen grains suspended in water. He theorized that behind apparent chaos, the grains actually gravitate around a balanced position from which they never move very far. This “wise” randomness, which seems to guard against or preclude extreme irregularities appealed to many economists who were trying to develop a model for financial markets using Gaussian distribution. In the beginning, the works of Brownians Jules Regnault (1834-1894) and subsequently Louis Bachelier (1870-1946), did not please Henri Poincaré (1854-1912), the world’s best known mathematician in his time, but they came back in full force around 1960 when the American economist Paul Samuelson was looking for a solution to the problem of pricing options. The Black-Scholes formula that we mentioned earlier is typically Brownian in nature.

Samuelson, Black and Scholes should have looked at the works of the French mathematicians Paul Levy and Norbert Wiener and the Japanese mathematician Kiyosi Itô. They had developed non-Brownian models because they had detected a worrisome inability in Brownian models to understand “rogue” (randomness) coincidences which they believed were typical of financial markets. For non-Brownians, the market is constantly shaken up by micro-crises and dangerous discontinuities. The French school of mathematics has produced great non-Brownian thinkers, such as Benoit Mandelbrot, founder of the “theory of fractals” in 1974. But their discontinuous models are harder to demonstrate, less reassuring and require large amounts of computer power and are therefore costly for banks to use. Consequently, in finance, these mathematicians are not so highly valued.
The argument is far from being purely intellectual in nature. In 2004, a group of “dissident” quants actually recalculated the ratings of Moody’s and instead of using the Brownian KMV model that the agency generally uses, they used a non-Brownian one. The AAA ratings of a few products were brought down in a ratio of one to five.
Paul Samuelson

The blame game
The debate between those who are pro and those who are anti mathematics is far from over. The real question is whether the movements of financial market can be subjected to probability analysis (ie.predicted). Some post-Keynesians, such as Michel Aglietta and André Orléan, believe that there is a “radical uncertainty factor” in finance and that it would be foolish to apply probability models to markets. Free market economists fear that if probability can never be calculated, the state will use the void to step in with tougher financial regulation. They’d rather leave it to the “invisible hand” of Adam Smith. These are neo-liberals, representend in France in the “Cercle des économistes,” a group of 30 mostly French economists that share theories and ideas.

So has mathematical finance done its mea culpa yet? Not yet. That will take a lot of time. It is true that in 2010 there are slightly fewer applicants for Nicole El Karoui’s masters program but the models remain and the big clean-up operation of the toxic substances is still underway. Mathematicians are not giving up the fight so easily, and the boldest amongst them do not think twice about revisiting 2008. They maintain they were not listened to enough. They believe that if there had been more maths on the markets, the crisis would perhaps not have taken place at all. And, in spite of the carnage in the markets in 2008, Ben Bernanke, the president of the US Federal Reserve bank, continues to vigorously defend the contributions of financial innovation.

Then there are those who call for a certain kind of “moral” financial mathematics. In 2009 Paul Wilmott, a PhD from Oxford and a well-known expert in quantitative finance, wrote what he called an ethical charter manifesto for the inventors of financial models and it is fast becoming the reference manual for those in the field.

Monday, July 2, 2012

History of Money & Banking

This article is made from the books by Niall Ferguson.

Niall Ferguson is a foremost historian in the study of money, wealth and banking

The lust for money started in USA when in 1524 Spanish Francisco Pizarro came to El Dorado and he with other army went to the money mountains of USA where the mines of gold and silver were common. The portable power was taken by Pizarro. Silver and gold was shipped to Europe and so crown of Spain got rich. Before this the only means of trade was normal good i.e wool for bread.But because of excess supply of silver in a short time the value of silver coins got low as compared to products sold so in long run the things did not work out well for Spanish Empire.
Money is not metal or paper but it's the trust and the belief of recipient, you can rely on people to borrow money from you and later pay it back. The borrowing and lending existed since 2nd century against products and their value. Lending is all that made the commerce today to come into being. Fibonacci  was the first mathematician to relate maths to business and helped with calculations of commerce. Computation of interest and book keeping was made by Fibonacci as well  and his book "Liber Abaci" which means "The Book of Calculation" deals much with using mathematics for banking and earning money. Italian cities were the first business hubs of world ,many money lenders and bankers were established there.Compensation of lender is what we call interest as in old times merchants were given loan and as we cannot predict weather so lenders demanded high interest/compensation.

Though in 12th century Roman Empire used coins for trade but it never got common amoung people and even in 12th Century there were Jews in Venice who were money lenders,Merchant of Venice tells the story of money lending Jews in Venice .Glasgow was old enough as well in banking and old books in Glasgow show that money lending was practiced even in 13th Century with interest as profit.
Niall Ferguson

From Renaissance Italy to modern world ,the money lenders were always villains due to high interest and their demand of anything back when money was not returned. In 15th century Italy the Medici family was top in money dealing and lending, they gained power and influenced many things in Florence. It was Niccolo Machiavelli who wrote their history and the Medici were the people who paid for Renaissance in Italy . Medici were basically known as tyrants or godfather and those who used to lend money. Medici family in few decades transformed themselves from back street money-lenders to modern bankers.Now for the first time in 14th century Medici money lenders became founders of the banking. Also Giovanni was the one who made banks across Italy and then began the story of Medici power as banking family in Europe. Medici were the first ones to make banking a powerful and respectable profession, they became pioneers of money exchange and the first money lending professionals to be gain respect and fame in society.

Leonardo Da Vinci and Michelangelo were among  the few who were paid high by Medici to provide art in Italy. Michelangelo worked for Lorenzo de Medici to give masterpieces. Medici were foreign exchange dealers and were founders of Medici Bank. Giovanni di Medicci was a top banker and he extended the banks around Italy. Cosimo de Medici ,son of Giovanni  later worked hard to maintain the power of banking. Cosimo (father of Lorenzo de Medici) was the master of Florence and controlled everything from law to politics to finance. A notable contribution to the profession of accounting by Medici family was the improvement of the general ledger system through the development of the double-entry bookkeeping system for tracking credits and debits. This system was first used by accountants working for the Medici family in Florence.Medici family thus in end of 15th Century was labelled as a family who was ruthless and powerful.

Cosimo  helped banking, trading and industry to develop and made Medici Bank the biggest bank of Europe.

From 1996-2006 there were 1-2 million each year to get bankrupt. While in America we say that many failed in start but made money later on e. g Henry Ford went bust in start and started all over again. The Bond market later turned banking into a casino game ,risk takers went to buy stocks and bonds and made fortunes overnight. Bond market funded wars, it created political powers. In modern time Bond Market  crushed Argentina, fortunes of most of us are linked to Bond market.
In 14th and 15th century many states in Italy were on war ,Sienna ,Tuscany and Pisa etc and all this fight was because of money and goods. Though financing war needs money and so Bond market was invented during Italian Renaissance where wars were done to capture capital, powerful armies used to take goods from weak forces and invested it to make themselves capable to fight with stronger armies. Florence people had a lot of money as there were many bankers were there.
While a war is taking place you as a money lender or bond trader are facing a high risk as you are facing the chance that war may ruin the city but if your clients win you will get a lot in return of the high risk you are facing. So even in old times risk was the actual measure of profit.

London later became the centre of Europe (or the world) and then in 18th Century the story of Rothschild family started.In 1750 Mayer Amschel Rothschild,worked at the Hanover Bank as a clerk a few years after his father's death. He made a lot of fortune in Germany and also expanded the bank across Europe including England and France, later his son Nathan came and made a giant banking empire.

Nathan Rothschild was a man of great obsession in banking .He was clever and hard working and he made the first big bank in London. Battle of Waterloo was a war on business ,to pay for war the British sold many Bonds. Nathan later went to get gold and silver from Europe and England's Exchequer while Duke of Wellington was also on march across the Europe to gather gold along with Nathan and while selling gold where the price was high or sending rest in London. So we say that London was premier place for gold exchange and was the market of top metals(gold ,silver etc). Prussian army together with British army under Duke of Wellington fought the battle of Waterloo and won against French.

Nathan undertook to transfer money to pay Duke of Wellington's troops, on campaign in Portugal and Spain against Napoleon, and later to make subsidy payments to British allies when these organized new troops after Napoleon's disastrous Russian campaign.His four brothers helped co-ordinate activities across the continent, and the family developed a network of agents, shippers and couriers to transport gold – and information – across Europe. This private intelligence service enabled Nathan to receive in London the news of Wellington's victory at the Battle of Waterloo a full day ahead of the government's official messengers.In 1818 he arranged a 5 million pound loan to the Prussian government and the issuing of bonds for government loans formed a mainstay of his bank’s business. He gained a position of such power in the City of London that by 1825–6 he was able to supply enough coin to the Bank of England to enable it to avert a liquidity crisis.Nathan took a risk to sell gold, he gambled to war of Waterloo and he bought many bonds and wishing that war won would lead Britain bonds to get high price, also while bonds were generated Britain was getting money for war as well. So we say that war/ politics and economy are related to the financial market.
Nathan Rothchild

Though the French war made Rothschild family rich and powerful and later they went on to bet American Civil war .Later cotton fields were used for bond market fuel, Rothschild's were always in New York and later Abraham Lincoln was supported by Rothschild for the cotton capture, for a while cotton trade was well off and it made a lot of profit for Rothschild. Rothchild  later had a Machiavellian thinking and chose to be feared rather than loved and even some British started to hate them due to their greed and the political problems due to their lust for money. Cotton from America was sold in Europe and bonds were traded in terms of cotton price(just like gold).

16th Century belonged to lending and financial market, while 17th century was about Bond market.

Bond market was pioneered by Bill Gross , the King of Bond Market .Bill manages around 700 Billion dollar Bond market in U.S.Bond market controls everything from GDP of a country to the salaries and pensions of people.Bond market financed wars i.e Waterloo and Italian State Wars, to get more money more bonds were issued at lower rate to people and so financing wars and other political activities.Bonds not only effect economy or politics but it effects pensions and inflation which effects everyone. At high inflation bond prices fall, i.e. Argentina is one of example. One Harrods was also in Argentina suggests that it was a rich country and they had a lot of resources(they had a lot of gold and silver but lack of management made it loose all).

With no foreign loan and no bonds ,the Govt. of Argentina had no option than print new notes and a time came when Argentina was out of paper and printing staff was on strike. Farmers were not bringing or breeding cattle as a price of a cow was equal to 2 pair of shoes or even farmers were in trouble. After the fall of Argentina the Bond market became less famous, price of food got high and many were hungry now, families ran out of cash and they sold goods to buy food. Keynes later came in Britain and described the bond market in his way. Keynes theories rely on a functioning bond market to support  economic of a country. Bond market gained rise again.

Joint stock market came into being in 18th century ,the "stock market" came into being in late 18th century and became top industry in 19th century. Future is always certain ,and stock market is prone to randomness and these can go bust like bubbles. Enron became corporate fraud in history of America (or world).STOCK MARKET BUBBLES CAN CAUSE MASSIVE IMPACT ,even bigger than the bond market or other financial trades.  

John Law was the father of stock market , he was the Scot who owned half of US and he was gambler, financial genius , convicted murderer and a man who indirectly caused French revolution. John Law was famous from Florence to Amsterdam to New York and London, he was the first greatest stock market guy. Law was later charged with murder and was prisoner but he fled to Amsterdam from jail and later went to Paris and also stayed there and made himself a legend.

Stock Market

Later trades were done in Asia where Dutch armies used to get goods like spices and used to sell them in Europe, East India company was first built by Dutch and goods were traded to Europe. People started to invest in East Indi company and made fortunes.
By 1610 THE DUTCH EAST INDIA COMPANY was ready to conquer the world, it was biggest multinational company(also monopoly trading company) of world. With 10,000 soldiers and 70 ships the network was across the world from Java to India. Every good was traded and their own stocks were traded in European company and many got wealthy due to this. John Law was in Amsterdam and was living on gambling and was also involved with Bank of Amsterdam.

In 1760 John Law arrived in Paris, France was in debt due to its wars. It was the perfect opportunity for John Law to change fortune of France, Law was a self taught economist and he suggested to print a lot of money. John Law constructed his theories in stock market and in casinos.Law was given chance in Paris because of Paris's financial debts and they were in need of profits and Law was asked to generate credit by financial engineering.He later went on to give credit at less interest and also suggested that France should make a monopoly company like East Indi Company. French went to USA and a company was built "Mississippi Company",John Law as its director. Many French merchants and investors were financing the company and this company made men millionaires and John Law was richest of them and later Law said" I am the economy". Law was the most powerful money man in history of France ,he controlled all financing banks, mints, trades and companies. Law later became the Prime Minister of France. John Law's money and stock schemes were Ponzi schemes.

John Law

John Law speculated that most profits will come from the French Colony in USA,LOUISIANA .The trade in this state was best under the management of Mississippi Company. Later share price of Mississippi company began to fell and angry crowd later gathered in Paris in front of Law's bank and started to stone the bank. It was a stock market bubble, Law later stayed in Paris and spent his time writing letters and continued gambling. France was later in loss and nightmare was unbelievable.  Later in 1929 came the stock market crash in Wall Street ,it was the most massive attack in history. Unemployment doubled and inflation rose as well. Technical reasons for such crashes are quite a lot but most relevant is herd behaviour(as described by Nietzsche that herd behaviour of many causes bubbles).According to Bell curve the probability are distributed according to frequency but in stock markets things are different and not follow a proper Bell curve i.e. heights of men are near 5 to 6 feet mostly and dwarves and giants are in tails but in stock markets everything has randomness which is not close to mean or which doesn't make quite a proper Bell curve.

Glasgow was the center of insurance since 14th Century. Modern insurance started in Scotland by the ministers of Glasgow(Ministers of Church of Scotland) in 1744 ,Robert Wallace and Alexander Wallace.They were both hard drinkers and mathematical geniuses.Robert Wallace was concerned with the orphans and the widows and while under insurance they were safe and so Wallace pioneered the method of insurance.Insurance is all about risk of future.Still Scotland is one of the top nation in terms of insured individuals or a top welfare state.

Japan also made a welfare fund(insurance fund) in 19th Century for armed forces or for Army Empire.All people in Japan were asked for insurance before World War.In 1945 Japan's idea of "Army Empire" died. Later Japan in 1950s decided to make itself a welfare state and all people were obliged for insurance and by 1970s it became the "Welfare Superman".Later in 1990s Japan became 2nd richest country in world.Milton Friedman later won Nobel Prize on his idea of "perfect elfare society" and he stated that if money supply went up then so did the price level. Welfare state concept was also practised in Chile but it collapsed. So economics later merged with democracy and state laws. 
Later in 20th Century (after 1960s) property was used as investment and profits.Property reserve was used as investment and profits.Property reserve was in past belonged to aristocratic families(especially in UK) and in UK hereditary land laws confirmed that no other was able to buy property and land.In 1990s though people realized that steady income is more important then income from assets(as they are divided when family grows).

People who were using rented accommodation later were encouraged by Government to get homes on mortgage , especially in U.S and U.K.In U.S 'Federal Mortgage Association" was made with reduced monthly returns , low interest and time spanning up to 30 years.After WWII societies expanded and in 1980s same thing started in UK and Government wanted everyone to buy a house on mortgage.In 1997 , America faced "Sub-prime Crisis" due to lending ease or due to people's default risk(loan was given to even the people with low income or earnings).It was a huge crises and so the property as investment was no longer used in U.S and even other regions.

Later Enron became the darling of Wall Street, Sharon Watkins was director of Enron and also many investors invested into Enron and it became one of the largest company in world. Enron launched largest gas pipeline in world, from USA to Brazil and in Argentina. Unlike John Law's system for his French company the system of Enron was fraud. In December 2001 Enron got bankrupt ,they were under 25 Billion debt. Ken Lay and other executives of Enron were charged with fraud and other securities fraud and were jailed .
Finance is much about risk than return, question is are you insured or hedged. Natural disasters also have huge impact on markets e. g Hurricane Katrina. The first insurance company was founded in 1744 in Edinburgh and was under management of Scottish ministers, Robert Wallace was a hard drinker and a math prodigy .He was pioneer of insurance fund and later the fund will become million dollar insurance industry. Robert launched widow fund and later in 18th and 19th century this widow fund expanded due to wars as soldiers were concerned about their sons and husbands. Insurance also contributes to welfare and economy of a country. Japan also was a pioneer in welfare. Nationalizing the risk was the key to welfare system. By late 1970s Japan became top in welfare and also it became the second richest country in world after US. Later in 1980s inflation was rising in London, due to risk.

Futures market later was formed in Chicago, futures contract assured hedging and later "Options" were formed. Future contracts are "Derivatives" and "Options" are smarter version of derivatives. Warren Buffet described derivatives as weapons of destruction of stock markets, one proof is that a big Hedge fund lost  almost all its value in a month. Later became the real estate business as price of land can go up and down. Money was borrowed for land and interest was earned by banks and clients expected the high price in future. But sub-prime borrowers were in this market due to greed of banks for interest(sub-prime borrowers are those who have not much assets but yet get loan as banks believe that rise of price of land will cover interest etc).This all led to sub-prime crisis in 2007 in US, it costed 153 billion to US. Later news were released that while in Sub Prime crisis almost one in two insiders were seen doing fraud.

Wall Street

Now let's come to Wall Street ,while during loans on houses many investors bought securities of A rated firms and so to save their money. Many had no idea what was going on, but they invested to avoid loss in Sub-prime crisis, lenders of Sub-prime mortgage were also investing in securities to save themselves. Those people who were unable to pay for their house were called for bids and were forced to sell houses, this caused loss to both lenders and home owners(loan takers).Next turn of investors was business but this is only limited to people with some capital or assets.
Total market of stocks/derivatives, insurance and bond market of world is 119 trillion dollars ,thanks to globalization and the top Stock Exchanges and their links. Money followed from Government to Government ,two banks such as WORLD BANK AND IMF were made in Washington D.C for stabilization of world economy.IMF and World Bank ensured that borrowed money by countries must be returned in a steady way, like Mexico got bankrupt after taking 30 Billion dollars and IMF took action and recovered money.IMF ensures that politicians are to be responsible to recover money from those countries.

Hedge Funds are funds that put funds for weeks and get massive returns, the master of Hedge fund was George Soros. His Theory of Reflexitivity suggests that financial markets are not perfect and so issues in these markets were read by him and he speculated from these and earned. Later Soros picked UK market and speculated British Treasury and went to speculate on trillion dollars. Soros speculation went right so in one single day he made million of pounds and that he became the world's richest hedge fund manager.

Merton and Scholes 's Long Term Capital Investments made million dollars by their hedging and speculation and later their option in top markets and the models to their speculation were quite accurate and so the risk of going bust was 0.01^20 so zero and later on they were awarded Noble Prize. Quants were predicting too and traders were happy too in all this case due to massive profits and ultimate profits were made. But quants were only using data of last 5 years, so later Long Term Capital crashed later and there came the 2007 crash. The crash that made quants feel like losers. Such crash was blamed for being faulty due to assumption of models of quants. Quants were good in models only for short-term and not for long term, while the one guy that did prove that quant models were wrong was Nassim Nicholas Taleb who warned the Black Swans in 2005-2006 and also suggested that Bell Curve is not to be used in stock or foreign market.

Nassim Nicholas Taleb,creator of Black Swan Theory.

China has many millionaires and also Chinese people are ones who save money for investment ,this makes them better gamblers than American or Europeans. In 2007(after sub-prime crisis) US needed 800 Billion Dollars in a year and China did gave the money so China became a banker to US. Why such a poor country like China will lend money to US? The answer lies in China's buying of dollars in Chinese market (China's business assets and stocks were traded in US dollars)thus raising value of dollar and so having more price in market. Quants are unable to predict Black Swans (as market is more complex these days and randomness is wild ) and human errors and also history of money market is known to few and only few take history into account these days. Thus we can say that crash in markets will keep on occurring unless we have enough knowledge about these issues.

As of 2006 the total world valued $47 trillion , while total stocks are worth $119 trillion and derivatives worth $470 trillion.