SERVING THE QUANTITATIVE FINANCE COMMUNITY

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Traden4Alpha
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The most foolish theorem ever...

January 29th, 2010, 9:43 pm

Yes, quality is a big issue. But can the scientist predict the quality? Can anyone predict the quality? How many people thought they were Faradays? What is the correlation coefficient between the scientist's prediction of quality and actual economic results? I'd wager it's extremely low (R^2<0.01), especially if you subtract the accumulated grant money, risk-adjusted interest payments on grants, and equity/incentive payments to the scientist.The Faraday example is a very good one on three levels. First, at what point in time did Faraday's ideas generate, say, $1 billion profits? It took decades to commercialize his inventions and more than a century to reach wide-spread adoption. Had Faraday been granted incentive payments, he'd have seen nothing (he had been dead for 13 years by the time Edison electrified a tiny part of New York City).Second, we got Faraday's results without any added incentives. If we can get more Faradays just by offering grant money, tenure-track jobs, and the occasional Nobel Prize, then why offer more?Third, if I give you $1 billion for incentivized science, then can you or anyone guarantee me a Faraday (= someone whose invention generates either: $1.5 billion of after-tax profits if I have to wait 5 years for profitability or $4.7 billion of profits if I have to wait 20 years; or $47 billion in profits if "my Faraday" gets results that take 50 years to commercialize)? And if my $1 billion doesn't buy a guaranteed Faraday, then take 1/(P(Faraday)) and multiply it by those require payoff figures. P.S. I do agree that quality matters, but it's not clear that scientific quality can be usefully increased because it's not observable until decades or centuries after the discovery.
Last edited by Traden4Alpha on January 28th, 2010, 11:00 pm, edited 1 time in total.
 
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hamster
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The most foolish theorem ever...

January 29th, 2010, 11:21 pm

QuoteOriginally posted by: daveangelQuoteOriginally posted by: BullBearQuoteOriginally posted by: daveangelso what is the problem mr bullbear ?A)1. leverage2. dumb assumptions................B)Taxes: The theorem uses the lousy regulation on corporate taxes to show how to screw the State in favor of corporations, i.e., wealth transfer from the State/individuals to Corporations!C)I can try to reformulate [metaphorically] the theorem to a more current theme, as follows:Consider 2 otherwise equally "wealthy" countries:a. Country A with no debt [e.g. China]b. Country B almost bankrupt and hence with a pile of debt [e.g. UK]Theorem: The debt/savings mix is irrelevant when an investor is deciding where to put his money / savings... So an investor should be indifferent while choosing to invest his savings in China or in the UK.I think you have a fundamental misunderstanding of M&M I (or more likely you dont and are just trying to be provocative). all this says is that the value of a firm or enterprise is independent of the way it is financed. the firm consists of assets (factories, people, brands) on the one side and liabilities and equity on the other. if there are no taxes and bankruptcy laws then the lhs (asset side) is independent of the mix of equity and debt. in most places interest expense comes above the line ie it is tax deductible meaning that there is an advantage to issuing bonds and int he limit the fim should be 100% debt financed. bankruptcy laws give the debt holders valuable rights but also give equity holders significant optionality. In reality, the conditions udner which M&M I hold cannot be observed anywhere so it is a moot theorem. however, it is a good framework to udnerstand capital structure.I agree 100% with daveangel.here is an alternative hypothesis to mm. It is about ownership and control. if you are equity holder you are owner of the firm and controls it, e.g. fire the manager. the debt and mezz holder disclaim control in exchange for fixed payments whereas rates depends on seniority. if you tell the manager to issue secured debt or some mezz you are increasing the probabilty of loosing ownership and control in exchange for higher average/exspected ROE. The residual payments to the equity fluctuates like hell, the more leverage, i.e. it is more likely you hit threshold of negative equity value. thus equity holder might feel pressured to influence manager's decision regarding buying, selling, enhancing, servicing, valuating the firm's assets. ie at the boundary equity/assets -> 0 the asset value become dependent of the capital structure. bullbearA) you might click here http://www.jstor.org/stable/1809766 and look at the date. 1958 !!! Half a century ago !!! Actually the first thoughts about worth of assets and the capital structure were made by Williams in the 30s. Whatever. the good point is that MM list all their ("dumb") assumptions. it is commonly known that assumptions are not the reality, many people spent a couple of decades relaxing them. B) you are little bit right. Why are interest payments to debt and mezz considered as costs? An accountant might explain it to you. But dont ask why. Accounting rules prefer equity holders. I suspect bcoz of historical reasons assuming equity holders are always entrepreneurs. Another reason is our monetary system which requires an incentive to borrow money. C) indeed debt/savings is irrelevant bcoz savings=debt. you have to invest savings (otherwise it's called hoarding=useless cash) what is mainly offering credit to someone else at the end of the day. even if people of one territory invest their savings somewhere around the world, they can use their capital income to pay taxes in order to serve their public debt at home. you might try the value of exspected GNP instead of savings.
 
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quantmeh
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The most foolish theorem ever...

January 30th, 2010, 12:37 am

QuoteOriginally posted by: hamsterhere is an alternative hypothesis to mm. It is about ownership and control. if you are equity holder you are owner of the firm and controls it, e.g. fire the manager. the debt and mezz holder disclaim control in exchange for fixed payments whereas rates depends on seniority. if you tell the manager to issue secured debt or some mezz you are increasing the probabilty of loosing ownership and control in exchange for higher average/exspected ROE. The residual payments to the equity fluctuates like hell, the more leverage, i.e. it is more likely you hit threshold of negative equity value. thus equity holder might feel pressured to influence manager's decision regarding buying, selling, enhancing, servicing, valuating the firm's assets. ie at the boundary equity/assets -> 0 the asset value become dependent of the capital structure. did you study M&M? these things are all discussed in conjunction with the theorem
 
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exneratunrisk
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The most foolish theorem ever...

January 30th, 2010, 9:10 am

T4A, your analysis on VC is very insightful and avoids border cases, like smaller scale financing, .. It shows to me that VC in the large, as daveangel stated, focusses on convertible type instruments, where VC wants to receive part of the business of the innovator? As an innovator with low cash, I might apply for funds, like in one of the EU research / innovation programs. But this forces me to become partner in a consortium, which again means selling part of my innovation (if I am a strong partner).All this requires sound pre-sales business planning.If I, as an innovator and business owner, want to stay completely independent, I need other financing ideas. Say, I print little beautiful colored pieces of paper, sell them at X for a guaranteed discount Y, extra services, ... on my final product, to be released in N months. This would allow for, at least partial, post-sales development and business planning and adaptation. It required adequate pricing and risk modeling and explanation, accounting standards, an adapted corporate finance theory (risk profiles), .... and a business infrastructure? And clear, it needs a strong innovation, because I need to disclose specifics, differential advantages, ...
Last edited by exneratunrisk on January 29th, 2010, 11:00 pm, edited 1 time in total.
 
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hamster
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The most foolish theorem ever...

January 31st, 2010, 1:21 am

QuoteOriginally posted by: jawabeandid you study M&M? these things are all discussed in conjunction with the theoremi didnt claim something new...
 
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Traden4Alpha
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The most foolish theorem ever...

January 31st, 2010, 1:32 am

Exner,Exactly! An innovator that wants to stay independent does face challenges in financing. Most banks and other debt providers will (should!) expect substantive collateral in the form of resalable long-term assets. If banks don't do this, then the banks are de facto equity investors who has given the innovator a free call option! (That's nice for the innovator but not so good for systemic risks to the financial system.) True equity investors rightfully dilute the innovator's ownership by taking a slice of the upside in return for non-negligible risk-of-zero-recovery. Moreover, given the moral hazard and information asymmetries of the situation, any outside investor SHOULD demand an outsized claim on the assets and/or equity or the innovator.If your capital needs are modest as a percentage of near-term revenues, then tactics that modify the cash-to-cash cycle will help. Anything you can do to delay payments to suppliers or accelerate payments from customers will let your reallocate working capital to capex. Your sales of "little beautiful colored pieces of paper" are a good example of this.
 
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hamster
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The most foolish theorem ever...

January 31st, 2010, 1:39 am

QuoteOriginally posted by: torontosimpleguyThe point is that M&M don't talk about time horizon in debt financing.When we talk about 'infinite' time horizon then cash outflow to serve the debt will eventually exceed the cash inflow from the business activity.the going concern assumption makes life easier bcoz it allows to plug perpetual into a model. e.g. you cannot reason going concern for structured products, project financing, etc... common sense ...
 
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BullBear
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The most foolish theorem ever...

January 31st, 2010, 12:37 pm

QuoteOriginally posted by: hamsterQuoteOriginally posted by: daveangelQuoteOriginally posted by: BullBearQuoteOriginally posted by: daveangelso what is the problem mr bullbear ?A)1. leverage2. dumb assumptions................B)Taxes: The theorem uses the lousy regulation on corporate taxes to show how to screw the State in favor of corporations, i.e., wealth transfer from the State/individuals to Corporations!C)I can try to reformulate [metaphorically] the theorem to a more current theme, as follows:Consider 2 otherwise equally "wealthy" countries:a. Country A with no debt [e.g. China]b. Country B almost bankrupt and hence with a pile of debt [e.g. UK]Theorem: The debt/savings mix is irrelevant when an investor is deciding where to put his money / savings... So an investor should be indifferent while choosing to invest his savings in China or in the UK.I think you have a fundamental misunderstanding of M&M I (or more likely you dont and are just trying to be provocative). all this says is that the value of a firm or enterprise is independent of the way it is financed. the firm consists of assets (factories, people, brands) on the one side and liabilities and equity on the other. if there are no taxes and bankruptcy laws then the lhs (asset side) is independent of the mix of equity and debt. in most places interest expense comes above the line ie it is tax deductible meaning that there is an advantage to issuing bonds and int he limit the fim should be 100% debt financed. bankruptcy laws give the debt holders valuable rights but also give equity holders significant optionality. In reality, the conditions udner which M&M I hold cannot be observed anywhere so it is a moot theorem. however, it is a good framework to udnerstand capital structure.I agree 100% with daveangel.here is an alternative hypothesis to mm. It is about ownership and control. if you are equity holder you are owner of the firm and controls it, e.g. fire the manager. the debt and mezz holder disclaim control in exchange for fixed payments whereas rates depends on seniority. if you tell the manager to issue secured debt or some mezz you are increasing the probabilty of loosing ownership and control in exchange for higher average/exspected ROE. The residual payments to the equity fluctuates like hell, the more leverage, i.e. it is more likely you hit threshold of negative equity value. thus equity holder might feel pressured to influence manager's decision regarding buying, selling, enhancing, servicing, valuating the firm's assets. ie at the boundary equity/assets -> 0 the asset value become dependent of the capital structure. bullbearA) you might click here http://www.jstor.org/stable/1809766 and look at the date. 1958 !!! Half a century ago !!! Actually the first thoughts about worth of assets and the capital structure were made by Williams in the 30s. Whatever. the good point is that MM list all their ("dumb") assumptions. it is commonly known that assumptions are not the reality, many people spent a couple of decades relaxing them. B) you are little bit right. Why are interest payments to debt and mezz considered as costs? An accountant might explain it to you. But dont ask why. Accounting rules prefer equity holders. I suspect bcoz of historical reasons assuming equity holders are always entrepreneurs. Another reason is our monetary system which requires an incentive to borrow money. C) indeed debt/savings is irrelevant bcoz savings=debt. you have to invest savings (otherwise it's called hoarding=useless cash) what is mainly offering credit to someone else at the end of the day. even if people of one territory invest their savings somewhere around the world, they can use their capital income to pay taxes in order to serve their public debt at home. you might try the value of exspected GNP instead of savings.This is my view:A) It doesn't matter when things were written it matters if they're still in academic curriculums or if bad quality theory hasn't still been rejected. You can teach useless theorems that used dumb assumptions in "History of Finance" not in "Finance".B.1) This is a huge problem: fragmentation of ownership. If equity is so disperse shareholders are not in control of managers. You get dependent of the decisions of a Board of Managers that may not be alligned with your interests and since equity is so disperse equity holders get lenient and let things go... A model with weak ownership is bad! Believe me. Turning firms into "capital markets" investments or IRA's investments is turning the economy into a giant casino full of gamblers. A firm always needs strong ownership. If there's a place where "democracy" is bad for society this is the case!B.2) Interest payments are well considered as costs. I fully agree with the accountants in this case. The problem here is fiscal. There's an incentive to over-leverage to get fiscal benefits. To me this is non-ethical. In the limit we'll get an incentive from the state to hold 100% debt as individuals and as corporations. Where do we get in the limit? To an unstable financial system with 100% debt and no savings that depends on Ponzi Schemers Central Bankers and Bankers printing paper money to keep the scheme running until 1. one day the future generations get screwed and/or 2. current generation depositors get screwed [by 1. asset bubble and 2. unstable financial system that can cause a bank run and wipe them out]!C.1) "savings = debt?" God, depositors are so screwed. Who do you think will finance a country or an over-leveraged economy?C.2) "you have to invest savings" People with savings don't want to hold any kind of risk! They're paid what? .1%/year? What kind of risks are they being paid for? Do you think deposits are always guaranteed by a printing machine? What's the power of argumentation of small savers regarding interest rates, financial system safety and price stability? None...C.3) This can hold in a closed economy where the "small guy" cannot argue with "power" but when it turns to external debt my friend you'll see the importance of how much leverage is there in a country/economy. Just check what's happening in Greece, Portugal, Spain and elsewhere...C.4) In this kind of system with so much leverage there's no risk free asset... Now imagine a retiree or a unempoyed guy, your young son that might get screwed because there's no safety in the system and you/he can't leave a risk-free reserve to him.C.5) Savings are the same of Reserves. I think that this consumist society forgot basic principles. People with savings hold them with the purpose of Reserves not anything else. What? Do you think people hoard cash to adore it? Everybody would like to live a great life everyday consuming everything but we just can't. First we need to earn it, then you can spend it! You can't leverage yourself for 30/40 years and screw the system if you get out of work. Let depositors or corrupt Bankers solve your problem. People save because they will need the money in the future and they can't afford to loose it otherwise they would apply it according to their decisions.D) This is a pure consumption society with irresponsible Bankers and Central Bankers. The Western Financial system will collapse! I'm sure about it.We're living in a world where the (E) may be a (D). People got a loan from an irresponsible Banker and used it in a firm as a (E). We can get to the limit where everything's a (D) in our economy, only savings are real (E). Do you know what it means to say (E) = 0? It's complete bankrupcy! Right now, the only "real" (E) available are savings and Depositors are holders of junk bonds without being aware of it! Moreover, they're being paid what? 0.1%? 1%? For holding a junk bond?E) Look at the USD/CHF chart. See how people behave when we live in such an unstable system. Why is there such a demand for CHF's nowadays? People are crazy coz' they are desperate to find a safe-haven...F) If 90% of people are holders of debt and 10% hold net savings, and since we live in Democracy we're getting to the point where a debt-overhang society can behave as a virus, using politics, until the last saver gets screwed.
 
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BullBear
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The most foolish theorem ever...

January 31st, 2010, 12:51 pm

QuoteOriginally posted by: Traden4AlphaAnd I'll go a step further. The real innovations that we need are not scientific, at least not in the hard sciences. Instead, we need innovations in management. Too much of modern management practice (what those nasty MBAs do) is based on 18th and 19th century paradigms of the industrial revolution. I totally disagree. What we need is to:a. go back to the Entrepeneurial MBA paradigm.b. more real innovations in science - the kind of innovations that produce wealth for society. We'll always need this kind of innovation.What we really don't need are:a. Economists - this class is responsible for such a mess we live in. They know nothing. What's the purpose of Economists?b. Quants - we don't need quant finance. We need to get rid of quant finance and gambling. Since this is a Quant forum I'll be under attack but I'm sorry this is my view. But don't get me wrong. We really need the skills of the Quants in lots of subjects. Quantitative degrees are useful it's just that they're in the wrong place...
 
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list
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The most foolish theorem ever...

January 31st, 2010, 12:55 pm

With MMT it difficult to believe that M&M did not clear understand the essence of its statement.They did talk about firm’s cost that assume to counterparties. Buying a firm investor purchases both E + D. If firm owners agree with the buyer price then we arrive at the MMT. On the other hand firm’s seller price is E – D that can be either positive or negative. In such broad problem that looks even broader than setting defined by demand-surplus the market price could be thought as a settlement price between the lower and upper boundaries which are defined by the seller and buyer prices, i.e. from the interval [ E – D , E + D ].
 
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Traden4Alpha
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January 31st, 2010, 2:23 pm

QuoteOriginally posted by: BullBearQuoteOriginally posted by: Traden4AlphaAnd I'll go a step further. The real innovations that we need are not scientific, at least not in the hard sciences. Instead, we need innovations in management. Too much of modern management practice (what those nasty MBAs do) is based on 18th and 19th century paradigms of the industrial revolution.I totally disagree. What we need is to:a. go back to the Entrepeneurial MBA paradigm.Agreed! A greater % of MBAs should be entrepreneurial although some % should be specialized for large organizations, too.QuoteOriginally posted by: BullBearb. more real innovations in science - the kind of innovations that produce wealth for society. We'll always need this kind of innovation.Maybe, maybe not.Innovation may create wealth for innovators but it erodes asset values for incumbents (making the debt of incumbents riskier and more equity-like). A given innovation only earns positive returns to society if subsequent innovations are delayed. As the mean-time-between-innovations drops, each innovation will fail to earn back the cost of discovery and implementation of that innovation before being supplanted by the next innovation. The result: too high a rate of innovation would be just as inimical to economic growth as too low a rate of innovation. Schumpter's creative destruction implies a second-order function that must balance creation and destruction to maximize growth.We seem to agree on the importance of innovation but disagree on the optimal rate of innovation.QuoteOriginally posted by: BullBearWhat we really don't need are:a. Economists - this class is responsible for such a mess we live in. They know nothing. What's the purpose of Economists?Indeed! And yet we seem to need someone to set capital reserve ratios, short-term interest rates, deficit spending strategies, GDP estimates and the like.QuoteOriginally posted by: BullBearb. Quants - we don't need quant finance. We need to get rid of quant finance and gambling. Since this is a Quant forum I'll be under attack but I'm sorry this is my view. But don't get me wrong. We really need the skills of the Quants in lots of subjects. Quantitative degrees are useful it's just that they're in the wrong place...You will get no disagreement from me over the Emperor's scanty apparel.But, as with economists, we have the issue that getting rid of the profession does not get rid of the underlying financial/economic problem. For better or for worse, we do need someone to please please please estimate prices, returns, risks, etc. associated with non-trivial patterns of cash flows, contingent payoffs, and fluctuating asset prices.By now, everyone on this forum who's suffered through my posts will know my opinion of pretending that physics can model prices (and the people behind them). It's no surprise that quant finance created a gambling atmosphere because it is based on the math of gambling (and fair gambling at that!). We need a version of quant finance based on unknown-loaded N-sided dice, Ponzi-defaulting casinos, and prevaricating particles.P.S. I really liked what you were saying in your previous post about (E) vs. (D). I too am concerned about the Western Financial system.
Last edited by Traden4Alpha on January 30th, 2010, 11:00 pm, edited 1 time in total.
 
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quantmeh
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The most foolish theorem ever...

January 31st, 2010, 4:17 pm

QuoteOriginally posted by: BullBeara. Economists - this class is responsible for such a mess we live in. They know nothing. What's the purpose of Economists?i bet you didn't study Economics
 
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BullBear
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The most foolish theorem ever...

January 31st, 2010, 7:11 pm

Last edited by BullBear on January 30th, 2010, 11:00 pm, edited 1 time in total.
 
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BullBear
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The most foolish theorem ever...

January 31st, 2010, 7:11 pm

Last edited by BullBear on January 30th, 2010, 11:00 pm, edited 1 time in total.
 
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BullBear
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The most foolish theorem ever...

January 31st, 2010, 7:11 pm

QuoteOriginally posted by: Traden4AlphaQuoteOriginally posted by: BullBearQuoteOriginally posted by: Traden4AlphaAnd I'll go a step further. The real innovations that we need are not scientific, at least not in the hard sciences. Instead, we need innovations in management. Too much of modern management practice (what those nasty MBAs do) is based on 18th and 19th century paradigms of the industrial revolution.I totally disagree. What we need is to:a. go back to the Entrepeneurial MBA paradigm.Agreed! A greater % of MBAs should be entrepreneurial although some % should be specialized for large organizations, too.QuoteOriginally posted by: BullBearb. more real innovations in science - the kind of innovations that produce wealth for society. We'll always need this kind of innovation.Maybe, maybe not.Innovation may create wealth for innovators but it erodes asset values for incumbents (making the debt of incumbents riskier and more equity-like). A given innovation only earns positive returns to society if subsequent innovations are delayed. As the mean-time-between-innovations drops, each innovation will fail to earn back the cost of discovery and implementation of that innovation before being supplanted by the next innovation. The result: too high a rate of innovation would be just as inimical to economic growth as too low a rate of innovation. Schumpter's creative destruction implies a second-order function that must balance creation and destruction to maximize growth.We seem to agree on the importance of innovation but disagree on the optimal rate of innovation.QuoteOriginally posted by: BullBearWhat we really don't need are:a. Economists - this class is responsible for such a mess we live in. They know nothing. What's the purpose of Economists?Indeed! And yet we seem to need someone to set capital reserve ratios, short-term interest rates, deficit spending strategies, GDP estimates and the like.QuoteOriginally posted by: BullBearb. Quants - we don't need quant finance. We need to get rid of quant finance and gambling. Since this is a Quant forum I'll be under attack but I'm sorry this is my view. But don't get me wrong. We really need the skills of the Quants in lots of subjects. Quantitative degrees are useful it's just that they're in the wrong place...You will get no disagreement from me over the Emperor's scanty apparel.But, as with economists, we have the issue that getting rid of the profession does not get rid of the underlying financial/economic problem. For better or for worse, we do need someone to please please please estimate prices, returns, risks, etc. associated with non-trivial patterns of cash flows, contingent payoffs, and fluctuating asset prices.By now, everyone on this forum who's suffered through my posts will know my opinion of pretending that physics can model prices (and the people behind them). It's no surprise that quant finance created a gambling atmosphere because it is based on the math of gambling (and fair gambling at that!). We need a version of quant finance based on unknown-loaded N-sided dice, Ponzi-defaulting casinos, and prevaricating particles.P.S. I really liked what you were saying in your previous post about (E) vs. (D). I too am concerned about the Western Financial system.I was being too naive during 2008-09 about the Western Financial System, Central Bankers, Bankers and paper money. Nassim Taleb is the guy we need to listen to.
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