The late, great Warren Zevon sang about werewolves living it up in his sardonic 1978 classic "Werewolves of London." It seems there may be more metaphorical truth to this song than meets the eye.

In his recently published book, The Hour Between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust (Penguin Press), John Coates brilliantly explains how physiological reactions to success, stress, threat and opportunity may be at the heart of the excesses that accompany, and can even define, the tail ends of financial peaks and troughs. A former Wall Street trader, Coates has some fascinating ideas for how a working understanding of this intersection of neuroscience and finance could benefit the risk management of investment banks, as well as the health of the risk takers themselves.

Former Wall Street trader John Coates' new book focuses on the intersection of neuroscience and finance.

The book itself contains a large amount of hard science, centering on the body's unconscious reactions to change in the immediate environment and how that in turn, via the natural production of hormones and steroids, dictates the conscious reaction to the situation. It also shows, as a working example, how this plays out on a trading floor, where such reactions can have an impact on both the health of the firm in question, and within the overall financial system.

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The results of various experiments make for truly interesting reading, with daily P&Ls being positively correlated to startling testosterone levels, but, for risk management, the further increase in testosterone that the very success generates, and the subsequent increasing tolerance for risky behavior that follows it. The book describes the euphoric rush at the peak of a successful trading day in a bull market, as a "point that traders and investors feel the bonds of terrestrial life slip from their shoulders and they begin to flex their muscles like newborn superheroes."

This observed behavior is counterpointed by the economic theory typically employed in the same banks, which assumes rational behavior from market participants, and begins to highlight where the two views diverge, creating the volatility and exuberance seen at the height of a boom. Moving easily between neuroscience, philosophy, pop culture and financial market behavior, Coates highlights differences between the ideal (rational) and the actual (potentially irrational) trading behaviors.

Equally important is the bodily reaction to underperformance and its ability to dictate a highly risk-averse state of mind. Again moving through the subconscious to the resultant conscious reaction, it illuminates the situation at the bottom of a bad day, and how body can initiate instinctual reactions to stress, leading at the extreme to an inability to act at all.

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The book concludes with a number of ways that such knowledge could be used to strengthen risk management, from hiring policy through active trading-floor risk management. The key lies between two core elements: the testosterone levels of the trader; and the trader's ability to deal with spiking levels of uncertainty.

The first point would seem to indicate that when bringing together a cluster of younger (less experienced in dealing with stressful conditions) men (higher testosterone), and spiking that cocktail with an environment of monetary and cultural reward, short-term performance is likely to increase the severity of tail events. A more diverse mix of gender and age is likely to dilute this significantly. It is also important to recognize and intercept extreme physiological responses, and suggestions include both longer-term incentive schemes and a more pastoral management of success and failure through the cycle.

These are excellent ideas, but it is also important to employ a risk monitoring system that tracks individual traders' successes and failures, including higher and lower P&Ls on specific positions and trades, which would logically seem to be early indicators of their subconscious drivers.

All in all, Coates's book is a must read for risk managers who would like to progress their firm's risk culture beyond end-of-day reporting.

Marcus Cree (Twitter: @marcuscreerisk) is vice president of risk solutions, in charge of client solutions for North America for SunGard's capital markets business, based in New York. At SunGard, Cree has worked in the implementation team for the Adaptiv risk solution as well as the solutions team in Europe. Before joining SunGard, he worked in the risk control unit of Deutsche Bank, the implementation team of Misys, and as an analyst for a U.K.-based stockbroker. In addition to the GARP FRM and AIMR qualifications, Mr. Cree holds a degree in mathematics and psychology from Leicester University.