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"A demon in our own design, markets, hedge funds and perils of our own innovation”, is a financial book that was written by the Wall Street veteran risk management consultant Richard Boockstabber about as suggested by the title,

  1. Hedge funds - An aggressively managed portfolio of investments that use advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (Paul, H., 2012).
  2.  Market – the process of establishing the value of goods and services. A market can also be defined as the place where people or parties go to exchange goods, either by barter or the use of monetary exchange.
  3. The “perils of our own innovation” is a phrase that to my understanding refers to the hazards that we bring upon ourselves by means of our own creations, in this book, such hazards are economical in nature, and they have a bearing on our financial well being.
  4. The theme of the book is that, the financial system of the world is very vulnerable to disasters arising from issues that at first glance appear to be of little or no significance. As implied by the chaos theory (a theory that studies dynamic systems behavior) that are very sensitive to the conditions at the beginning. These small variations in the initial conditions bring about outcomes that diverge too widely for such dynamic systems. This renders it very difficult, and sometimes impossible to make long term predictions. Its butterfly affect these are the sensitive dependencies on the conditions at the beginning or the initial conditions (Paul, H., 2012).

In this book, Boockstabber discuses the very important role that asset liquidity plays in the markets, which is not always fully appreciated, and also present a theory, normal accidents that lead to very high complexities and tight coupling. He uses the following in his review:

  1. The three islands nuclear disaster. This was a partial nuclear meltdown which occurred at a nuclear power plant on the three islands, dauphin county in Pennsylvania, USA, on the 28th march 1989. In this case, the very small incident (a blocked valve) caused the introduction of a policy that prevents the clearance of the building of new nuclear power plant projects and as a result the colleges and the universities do not carry out research in this field. This implies that, the US has to rely on Japanese engineers to do the construction work in the event that a new nuclear power plant is needed.
  2. The space shuttle Columbia which disintegrated following its reentrance onto the earth’s atmosphere on the 1st of February in 2007, killing all seven members of crew onboard. NASA had thoroughly assessed the risk of the shuttle having an accident and Feynman had estimated the probability of the challenger clashing to be 1:100000, though this figure were later toned down. The financial implications went far beyond imaginations, the challenger innovation, which gad cost billions of dollars and more than 30 years to complete was scrapped, all for a simple miscalculated risk or assumption.
  3. The clash of the domestic flight ValuJet Flight 592 in Miami, Florida on the 11th of May in the year 1996. This accident involving the domestic flight from Miami, Florida to the city of Atlanta, Georgia, killed all the 105 passengers on board and the crew of five. It was caused by a fire in compartment D, an area which has no access to outside air, which means that a fire in this area will burn itself when it has exhausted all the oxygen supply. It would have been impossible to place a risk that a fire from this compartment would have such devastating effects.

All these accidents were what can be categorized as normal accidents, yet they had infinitesimally small chances of occurring and had abnormally large financial implications. It would not have been possible for a risk manager to foresee the accidents; they can only be accommodated in the chaos theory, small seemingly insignificant conditions with far reaching financial implications. They are the butterfly effect.

In this book, Boockstabber also attacks the efficient market hypothesis; a theory that it is not possible to “beat the market” stock. This is due to the fact that, the efficiency of the stock market is responsible for the fact that the prices of the shares reflect and incorporate all relevant information. That is to say that, it is not possible for investors to either purchase or sell shares whose proper value has either been inflated or deflated. The implication of this is that the investor can only get higher returns for his or her investment. This can be achieved by trading making investments that are at significantly higher risks of failure, which fends off competition)

 Boockstabber attacks this theory using biological and evolutionary analogies “One of the curious aspects of worsening market crises and financial instability is that these events do not mirror the underlying real economy. In fact, while risk has increased for the capital markets, the real economy, the one we live in, has experienced the opposite. In recent decades the world has progressively become a less risky place, at least when it comes to economics. In the United States, the variability in gross domestic product (GDP) has dropped steadily. Year by year, GDP varies half as much as it did 50 years ago. The same holds for disposable personal income, with greater stability in economic productivity and earnings, and with greater and broader access to borrowing the personal income of the average worker have considerably become stable in the recent years.” (Bookstaber, 2007; 16).

If the system is self deterministic, why Boockstabber asks, the financial contradictions that exist? Is it possible that an investment can gain value steadily at a very fast rate and simply deflate as fast once it catches the public eye? What led to the Japanese stock bubble, the Nikkei index tripled in the period between 1986 to early 1990, the halved over the following nine months? In the USA, there was the internet bubble that saw the value of the NASDAQ rise fourth fold in a little more than a year and then decline by a similarly amount the following year. Did the market values of these increase and then decrease in such a short period? Was this brought about by market forces?

Boockstabber also applies the argument that, in a real efficient market the returns accrued by the ordinary average investor should be the same as those accrued by the Wall Street investor since they are all on the same footing in terms of taking risks. An average person can make the observation that this is not what happens.  

However, Boockstabber concedes that the trend has been improving in the recent past.

The main puzzle in this book is; if trading technology and financial economics devoted into the field of modern economics are so big, why does the financial market occasionally get out of control? Why are there recessions?  Why are these recessions not foreseeable?

Boockstabber places the blame on the conduct of the institutional investor’s employees. First, the regulations hinder them from doing rational things and secondly, the hardships of the structures often motivate them to do wrong things (Turner, BA., 1978).

Critics

The author of the book “A Demon of Our Own Design” claims to have been around when the market clash of 1987 occurred. He also witnessed the 1998 market fund debacle, and he has also been working in the Wall Street risk management business. Yet with all this accolades, he was unable to foresee the 2007 financial recession, which occurred the very same year that his book sent to publication. If he is the flawless risk manager that he claims to be, at least he should have seen this one coming. However, to his credit, he was able to foresee some future financial crisis, though he did not place this supposed crisis. One can even go as far as claim that he only predicted this calamity to make the book more appealing (Deming, 1989).

In conclusion, Boockstabber argues that, liquidating moves the market; however, a lot of scholars disagree. Their main point being that the main factors that drive the markets of the capitalist economies are greed and fear. Greed leads to the taking of unrealistic risks while fear is known to keep the investors from good opportunities. However, a good investor is one who possesses both elements in the right quantities. He neither takes too big a risk nor shies away from a good opportunity. 

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