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Quantitative Finance and the Financial Crisis

Quantitative Finance and the Financial Crisis

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Published by: cyojoe on Dec 15, 2009
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Petrich 1Joseph PetrichMr. McGillPolitical Science Honors, p 518 December 2009Quantitative Finance and the Financial Crisis
Introduction
The last thirty years have witnessed astounding growth in quantitative finance. There aretwo main ideas of economics that have facilitated this: market efficiency and no arbitrage.Market efficiency is “the idea that the financial markets price every asset correctly” (Joshi 910).This means that the only factor to take into consideration when distinguishing assets is their risk;that is, a government bond might offer low growth with low risk, while a “green” technologystock could offer high prospective growth with lots of risk, and these risks/rewards will be pricedcorrectly by investors. The other principle, that of no arbitrage, means that it is impossible tomake money with zero risk. One should not be able to trade dollars for Euros, Euros for Pesos,and then Pesos for dollars, and end up with more or less money than he started with. In the casethat an arbitrage situation does arise, investors will quickly spot it, capitalize on it, and themarkets will adjust themselves to eliminate the arbitrage possibility.With these principles in mind, there are four basic areas of finance in which mathematicsis used: derivatives pricing, risk analysis and reduction, portfolio optimization, and statisticalarbitrage. Derivatives pricing is the use of mathematics to set prices for securities traded onmarkets anywhere. Portfolio optimization deals with maximizing return for a certain allowablelevel of risk; this is seen in retirement plans. When an employee is young, higher risk isacceptable, but as retirement nears, safer securities must be secure to ensure healthy retirement.Statistical arbitrage makes use of market
inefficiency
, exploiting any mispriced securities thatcould result in arbitrage (essentially free lunch).
 
Petrich 2The part of quantitative mathematics that will be discussed in this paper is risk analysisand reduction. All financial institutions, from investment banks to insurance companies, need tohave an idea of the risk in all assets, so they know how and when to trade securities to maximize profit. Mathematicians, physicists, and engineers who work in the financial sector, especially inrisk analysis and reduction are called quants. Quants created the Wall Street familiar today, andhelped create the most recent financial crisis, however, they will continue to play a large role inthe financial sector, furthering the world-wide economy and revolutionizing investmentstrategies.
A Brief History of Quants
According to Mark Joshi, an professor at Melbourne University, and a widely publishedauthor on all things financial and mathematical, a quant is someone who “designs andimplements mathematical models for the pricing of derivatives, assessment of risk, or predictingmarket movement” (Lindsey 1). These mathematical models have become invaluable to traderson Wall Street, as well as around the world, since the development of the options-pricing model by Fischer Black and Myron Scholes, which was published in 1973. The model, along with the beginnings of the Chicago Board Options Exchange, led to the trading of hundreds of millions of options on exchanges worldwide. While the first quants on Wall Street were physicists andmathematicians adopting the Black-Scholes Model and designing their own in the early 1970s,and the public realization of mathematical trading did not occur until the 1990s, mathematicianshave been involved in finance and risk management for years.Pierre Fermat, known best for his “Last Theorem,” developed mathematical ways todistribute the pot of money in gambling when a game was left incomplete. Similarly, Johan deWitt and Christian Huygens developed ways to fairly calculate an annuity payment based on theholder’s age. These are two examples of many mathematicians in the 1600s that pioneered in a
 
Petrich 3field known as
Game Theory
, which is the mathematical description of all things probabilistic or random. In this field, the flip of a coin could be considered the most basic system, and theworld’s system of financial markets the Holy Grail. The genius of Black and Scholes, and later Merton, who received the Nobel Prize in Economics along with Black, was only recognized because of the explosion in computing power, and the advent of personal computing.The Black-Scholes model, based on Bachelier’s 1900 thesis (Joshi 910), when solved for most options yields a
 partial-differential equation
, or PDE. These equations are often quitedifficult to solve by hand, and can take pages of calculations. When these equations must besolved hundreds of times to make a certain trade, and the price is fluctuating by the second, ahand-calculation of PDEs is not practical. Computers had already been programmed to solvethis type of equation before, in the physics and engineering world, and it took little effort toadapt them to the financial sector. Even with the ease of computing the risk of traded options, itis likely that quantitative finance would never have taken off it were not for an increasedvolatility due to unsettled atmosphere of the Cold War era. Until that increase in uncertaintyoccurred, investors were content to trust their instinct.Thus Wall Street began to hire quants, and, as a new field, it might be wondered where practitioners of sufficient experience and skill level were found. The answer is that Black andScholes were not the only mathematicians working to model the markets, though they werehugely influential. An abundance of small hedge funds sprouted up across the river fromManhattan in New Jersey, where their research was kept fairly private, and personnel movedrapidly. These start-ups generally recruited Ph.D. candidates in mathematics, physics, andengineering. Eventually some of these start-ups pitched their services to large investment banks,and the quant revolution was in full swing. Today, there are undergraduate and graduate degreesin financial engineering, quantitative finance, and qualitative finance, all of which are designed

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