The Huge edifice of Modern Finance, the "superego" of the financial industry, is built on sand. Its foundation is the illusion that the radical uncertainty that prevails in our large, complex, and messy world can be understood and exploited through the calculable risks of a small, simple, rational model.
That the illusion persists despite ample compelling and damning evidence is perhaps Modern Finance's singular achievement. The financial sector, powered by Modern Finance, has regularly generated financial crises, both large and small. The 1994 bond market crash, for example, blew up the VaR risk management models that had been introduced shortly before. The global financial crisis of 2007 and 2008 then brought a repeat in CinemaScope.
The legendary hedge fund Long-Term Capital Management collapsed in the late 1990s because of an overreliance on the option pricing theory.
Moreover, a straight line can be drawn from MPT, which provided the theoretical basis for CMOs, to the global financial crisis.
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