Kent Osband - Pandora’s Risk: Uncertainty at the Core of Finance

Pandoras Risk

Columbia University Press

Publishers Since 1893

New York Chichester, West Sussex

cup.columbia.edu

Copyright 2011 Columbia University Press

All rights reserved

E-ISBN 978-0-231-52541-1

Library of Congress Cataloging-in-Publication Data

Osband, Kent.

Pandoras risk : uncertainty at the core of finance / Kent Osband.

p. cm.

Includes bibliographical references and index.

ISBN 978-0-231-15172-6 (cloth : alk. paper) ISBN 978-0-231-52541-1 (ebook)

1. Financial risk management. 2. Financial risk. I. Title.

HD61.O83 2011

658.155dc22

2011002618

A Columbia University Press E-book.

CUP would be pleased to hear about your reading experience with this e-book at .

This book is printed on paper with recycled content.

References to Internet Web sites (URLs) were accurate at the time of writing. Neither the author nor Columbia University Press is responsible for URLs that may have expired or changed since the manuscript was prepared.

To those who fear more to pretend to know

than to admit they dont

The revelation came one lazy summer evening. I had just dozed off when two goons broke into my house, threw a sack over me, and whisked me away. In an instant that felt like an eternity they took me to their lair and hauled me trembling before their leader.

Suddenly I heard His voice. Have no fear, my son. I have brought you here for blessing, not punishment.

Is that your escort service? I asked.

Those are your guardian angels. You arrived safely, did you not?

And the sack?

A spacesuit. You wouldnt survive the journey without one.

Why no eyeholes?

None can look at me and live. But l will let you glimpse my hand. Do you see it? Two slits miraculously appeared in the sack. Through them I saw the most wondrous hand I had ever seen. It was the color of

Do not tell anyone the color, He said. You people torment each other enough in my name already. Just watch as I show you. He turned His hand to reveal enormous emeralds, with more facets than I could count and a different number cut into each one.

Theyre dice! I cried. And youre playing them. Einstein must have been stunned.

He was. But so was Bohr when I showed him what I am about to show you. What do you see next to my hand?

Nothing. Its pitch black.

It is a black hole. No light can return once it enters. But watch this. He thrust His hand into the black hole and pulled it back out. Th e dice were perfectly aligned and displayed the number 622,487.

Fantastic. Hawking was right. You do sometimes throw dice where they cant be seen.

Keep watching. Again He threw the dice and pulled them back from the abyss. The number was exactly the same: 622,487.

What a coincidence, I said. Nothing has changed.

You are not watching carefully enough.

I looked again. Diamonds had replaced emeralds, with more facets than before. You changed your dice!

And what does that imply?

The risks have changed.

I heard murmurs of approval. Congratulations, He said. You have passed the first test. Not many people in finance do.

Im surprised. Its so obvious.

Not when you dont see the dice. Then you have to infer change from the evidence. Thats murky. Most of finance presumes the risks are clear.

Why not just announce every change?

Because that would break Pandoras bargain.

Bargain? With Pandora? I dont understand.

I dont expect you to. Just relay my useful message.

The message that You change your dice without telling us? How can that be useful?

Because knowing the right question is better than answering the wrong one.

But how do You expect us to find the answer?

By using the organ I gave you for experimentation, discovery, and delight.

A dirty thought crossed my mind. He must have read it. You fool, He thundered. I meant your brain! Lightning bolts flew and a mighty wind knocked me down. I knew my end was near.

Suddenly a womans voice broke in. Stop, Prometheus! Hes just a man. What do you expect?

The heavens stilled. Thats better, she said. And stop impersonating the gods. Theyll have you arrested and your liver eaten out.

They have and they do.

Yes, but why aggravate the charges?

Youre right, Pandora. Men are not worthy of our gifts.

Not yet, but they will be. We give to make them worthy. Has man not proved worthy of the fire you gave?

Yes, it has created far more than it destroyed.

A gentle hand helped me to my feet and removed the sack covering my head. I saw an ancient but strikingly beautiful woman. Her eyes sparkled. Hello, she said. I am Pandora. And if you look up youll see Prometheus, the titan you mistook for a god.

My mind raced too fast for words. Pleased to meet you, I finally mumbled.

I doubt it. More likely you mourn the havoc weve allegedly wreaked on the world, through fire, famine, pestilence, and the curse of labor.

Actually, I wasnt so worried about the fire. Prometheus is on our side.

Unlike me?

Yes, unlike you. You opened the box. You shouldnt have. Zeus told you not to.

We made a deal. It was a bargain for mankind.

Pandora, youre sick. You get too curious, unleash all kinds of evils, and then call it a bargain because were left with hope?

There was good in the box too. Countless discoveries. Treasures at the edge of imagination.

Great. So you let them slip away as well. Oh, I forgot. We can hope to find them again. Thanks a lot.

Pandora winced. Stop, said Prometheus. Youre torturing her with a lie. The story doesnt even make sense. But whenever Pandora hears it, it is as if the eagle eats her liver too.

What do you mean the story doesnt make sense?

Think about it. What was the point of the box?

To keep bad things away from mankind.

Was it working?

Yes, until Pandora opened the box and the bad things rushed out.

Men knew nothing about the contents before?

I dont see how they could have.

So why was it good that hope stayed in the box? Why didnt hope rush out to find mankind, the way the bad things did?

I was stumped. I dont know. I wasnt there.

And yet you judge. Pandora, tell him what life was like before you opened the box.

It was serene, she said. Too serene. Prometheus brought men only the fire outside. They had none in their bellies. No hunger for adventure, no thirst for discovery. Opening the box opened their eyes to opportunities.

And people fault you for that?

They fault me for the risks. Opportunity always comes with risk. Without risk they hadnt even needed hope. It was locked away in the box.

Locked? The box was locked?

Of course it was locked. Otherwise risk would have nudged it open. Zeus held the only key.

Which you stole like Prometheus stole fire?

I never stole, said Pandora. I bargained. Zeus handed it to me fair and square, in return for my pledge to guard the box for all eternity.

For what purpose? To keep hope inside?

No, to keep the risk that emerged from getting back in.

And why did Zeus demand that?

To remind men that they are not gods.

It took me a while to digest this. Pandoras version fit the evidence better than the original did. Only I still didnt understand the bargain. What does it mean to keep risk outside the box?

It means that men will never fully know the risks they face. Th ey will have to guess, and face the new risks their guesses impose. No man will ever fully master his universe.

Can men recapture certainty by averaging over a large number of events?