The Money Formula

CHAPTER 1Early Models

“Nature, and Nature's Laws lay hid in Night.

God said, Let Newton be! And All was Light.”

—Alexander Pope

“Beelzebub begat Law

Law begat the Mississippi

The Mississippi begat the System (etc.)”

—Het Groote Tafereel der Dwaasheid (The Great Mirror of Folly)

The mathematical models used by quants are based on ideas and concepts developed by generations of economists. They in turn were heavily influenced by physics. But is it really possible to model the markets as a kind of physical system, or is quantitative finance more like a set of mathematical tricks for betting on markets? This chapter traces the development of economics; looks at the basic assumptions such as equilibrium and rationality that have shaped both economics and finance; and considers the dual nature of quantitative finance, as exemplified by two men – John Law and Isaac Newton.

In 1705, Scotland was contemplating union with its neighbor England. The English economy was riding high, and Scotland's leaders thought this might be an opportune moment for a merger. However, not everyone thought hooking up was a good idea. One person who argued against it was the banker, gambler, and social climber John Law. He went so far as to propose an entirely new monetary system for Scotland, which he claimed would go beyond the English system and in a stroke solve his country's monetary problems while boosting trade.

Part of England's success was due to its newly created central bank, the Bank of England, ...