Volatility of an Impossible Object Risk, Fear, and Safety in Games of Perception
The global financial markets walk on the razors edge of empiricism and what you see is not what you think, and what you think may very well be impossible anyway. The impossible object in art is an illustration that highlights the limitations of human perception and is an appropriate construct for our modern capitalist dystopia. Famous examples include Necker’s Cube, Penrose Triangle, Devil’s Tuning Fork, and the artwork of M.C. Escher. The formal definition is “an optical illusion consisting of a two-dimensional figure which is instantly and subconsciously interpreted as representing a projection of three- dimensional space even when it is not geometrically possible” (1). The fundamental characteristic of the impossible object is uncertainty of perception. Is it feasible for a real waterfall to flow into itself; or for a triangle to complete itself in both directions? The figures are subject to multiple forms of interpretation challenging whether our naïve perception is relevant to understanding the truth. The impossible object is of vast importance to mathematics, art, philosophy and as I will argue… modern pricing of risk.
Modern financial markets are a game of impossible objects. In a world where global central banks manipulate the cost of risk the mechanics of price discovery have disengaged from reality resulting in paradoxical expressions of value that should not exist according to efficient market theory. Fear and safety are now interchangeable in a speculative and high stakes game of perception. The efficient frontier is now contorted to such a degree that traditional empirical views are no longer relevant.
The volatility of an impossible object is your own changing perception.
Our cover illustration pays homage to M.C. Escher’s 1961 masterpiece Waterfall and is intended to be an artistic abstraction of the self-reflexive mechanics of modern monetary theory. In a capitalist cityscape the aqueduct begins at the waterwheel of monetary expansion churning out a torrent of boundless fiat currency that streams through the dense metropolis. The river of money flows from the edge of the aqueduct into the waterfall of deflation and then over the waterwheel suspended in a never- ending cycle of monetary expansion and crisis. Beneath the city the fires of inflation burn threatening to one day consume the monetary mechanism. Is the reflexivity of flowing fiat currency the solution or the very source of the paradox? We don’t know.
Likewise how certain are we that the elevated two-dimensional prices of risk assets and low spot volatility have anything to do with fundamental three-dimensional reality? In this brave new world volatility is an important dimension of risk because it can measure investor trust in the market depiction of the future economy. The problem is that the abstraction of the market has become an economic reality unto itself. You can no longer play by the old rules since those rules no longer apply. I know what you are thinking. You didn’t get your MBA to be an amateur philosopher – your job is to make cold-hard decisions about real money – not read Plato. You are out of luck. For the next decade this market is going to reward philosophers over students of business. Why? Because the modern investor must hold several contradictory ideas in his or her head at the same time and none of them really make any sense according to business school case studies. Welcome to the impossible market where…
Full report here, ArtemisVegaQ32012_Volatility of an Impossible Object