Wild Randomness

From The City Journal:

Fin In the summer of 2008, wheat and corn prices shot up across the globe. Pundits provided seemingly convincing explanations: grain was becoming scarce and thus more expensive because mainland Chinese were changing their eating habits and needed lots of it to feed their cattle—or perhaps because fear of oil shortages, combined with ecological fads, was leading consumers to adopt corn-based ethanol. Yet one year later, the Chinese are eating basically the same food as last year (feeding habits change very slowly), ethanol production is more or less at the same level, but the price of grain and corn on the Chicago market is back down again. How to explain the volatility of prices when production levels remain essentially the same?

The reason: grain or corn prices may at any point in time be driven more by speculation than by actual harvests. The rule applies to all transactions on financial markets, including oil, stocks, and derivatives. This is one of many examples that Rama Cont offers to describe how the real economy and the financial markets follow different rationales. In the short term—which can mean several years, in practice—the connection can be tenuous at best and difficult to model. If the connection were closer, Cont would know: he is at the forefront of the new science of financial modeling.

More here.