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McGill Political Science Honors, p 5 18 December 2009 Quantitative Finance and the Financial Crisis Introduction The last thirty years have witnessed astounding growth in quantitative finance. There are two 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” technology stock could offer high prospective growth with lots of risk, and these risks/rewards will be priced correctly by investors. The other principle, that of no arbitrage, means that it is impossible to make 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 case that an arbitrage situation does arise, investors will quickly spot it, capitalize on it, and the markets will adjust themselves to eliminate the arbitrage possibility. With these principles in mind, there are four basic areas of finance in which mathematics is used: derivatives pricing, risk analysis and reduction, portfolio optimization, and statistical arbitrage. Derivatives pricing is the use of mathematics to set prices for securities traded on markets anywhere. Portfolio optimization deals with maximizing return for a certain allowable level of risk; this is seen in retirement plans. When an employee is young, higher risk is acceptable, but as retirement nears, safer securities must be secure to ensure healthy retirement. Statistical arbitrage makes use of market inefficiency, exploiting any mispriced securities that could result in arbitrage (essentially free lunch).
Petrich 2 The part of quantitative mathematics that will be discussed in this paper is risk analysis and reduction. All financial institutions, from investment banks to insurance companies, need to have 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 in risk analysis and reduction are called quants. Quants created the Wall Street familiar today, and helped create the most recent financial crisis, however, they will continue to play a large role in the financial sector, furthering the world-wide economy and revolutionizing investment strategies. A Brief History of Quants According to Mark Joshi, an professor at Melbourne University, and a widely published author on all things financial and mathematical, a quant is someone who “designs and implements mathematical models for the pricing of derivatives, assessment of risk, or predicting market movement” (Lindsey 1). These mathematical models have become invaluable to traders on 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 and mathematicians 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, mathematicians have been involved in finance and risk management for years. Pierre Fermat, known best for his “Last Theorem,” developed mathematical ways to distribute the pot of money in gambling when a game was left incomplete. Similarly, Johan de Witt and Christian Huygens developed ways to fairly calculate an annuity payment based on the holder’s age. These are two examples of many mathematicians in the 1600s that pioneered in a
Petrich 3 field 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 the world’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 quite difficult to solve by hand, and can take pages of calculations. When these equations must be solved hundreds of times to make a certain trade, and the price is fluctuating by the second, a hand-calculation of PDEs is not practical. Computers had already been programmed to solve this type of equation before, in the physics and engineering world, and it took little effort to adapt them to the financial sector. Even with the ease of computing the risk of traded options, it is likely that quantitative finance would never have taken off it were not for an increased volatility due to unsettled atmosphere of the Cold War era. Until that increase in uncertainty occurred, 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 and Scholes were not the only mathematicians working to model the markets, though they were hugely influential. An abundance of small hedge funds sprouted up across the river from Manhattan in New Jersey, where their research was kept fairly private, and personnel moved rapidly. These start-ups generally recruited Ph.D. candidates in mathematics, physics, and engineering. 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 degrees in financial engineering, quantitative finance, and qualitative finance, all of which are designed
Petrich 4 to prepare students for a career as a quant. In order to understand the development of the field of quantitative finance, it is necessary to understand the most recent financial crisis – the panic of 2008 - and its aftermath. The Panic of 2008 In the months between March and September of 2008, the federal government made the largest intrusion into finance and free markets since the Great Depression by encouraging a merger between the failing investment bank Bear Sterns and JPMorgan Chase. Ignoring the backlash from this government action, Federal Reserve Board Chairman Bernanke and thenSecretary of the Treasury Paulson decided to orchestrate a bail-out of Fannie Mae and Freddie Mac, the largest government-sponsored private-mortgage-based securities holders in the nation. This action caused criticism from both parties, but Bernanke stuck by his strategy, proposing that keeping credit liquidity by keeping banks open would help make the crisis shorter, though it might encourage risky behavior. Then, on September 11, New York Reserve Board Chairman Geithner approached Bernanke and Paulson, informing them that Lehman Brothers Holding Inc would likely not be able to operate past the weekend, and the three men began anxiously pursuing a buyer for Lehman. Two candidates arose, Bank of America, and Barclays (a large bank in the UK). At this time, Christopher Flowers (a self-made billionaire) was called in to assist in negotiating terms of a buyout of Lehman; he was also asked to come as a potential partner in the deal. However, that same week, he was summoned to AIG, where he was briefed about the immanent failure of that company due to a greater number of defaults on mortgages (which meant AIG would need to post more collateral to its own investors). At this news, Paulson, Bernanke and Geithner called a meeting at the New York Reserve Bank in lower Manhattan. CEOs from all
Petrich 5 the largest banks (except Bank of America and Barclays) attended, as well as CFOs and regulators. At this point, Paulson broke the news that the government would not be able to save Lehman, and that, though all the people in the room were normally competitors, they should try to work together to buy out whatever parts of Lehman could not be taken on by Bank of America or Barclays. This would be necessary to keep Wall Street running smoothly, and to prevent more banks from failing – something all the attendees should wish for. At the end of Paulson’s speech, Geithner divided the men into three groups – one to assess Lehman’s assets and the amount necessary to finance, one to figure out how Lehman’s assets could be sold, and one to prepare in for a Lehman bankruptcy. The next morning, September 12, the men reconvened and set to work. Many of them had come to the same conclusion – that their bank could be the next to suffer, and so they proposed to Geithner that some sort of fund should be set up to help whichever bank next failed. Instead of welcoming the idea, Geithner rebuked the bankers, telling them to focus on Lehman. It was a general consensus, however, that a metaphorical firewall must be built to keep more banks from failing, and it was agreed that Merrill Lynch was that wall. Merrill CEO John Thain met with Bank of America CEO Ken Lewis about buying a 9.9% stake in Merrill, but Lewis was disinterested. He wanted complete control or nothing. Goldman Sachs expressed an interest in buying a share of Merrill, however, so meetings were scheduled between Merill and Goldman as well as Merrill and Bank of America. By this time, however, the true plight of Lehman was clear – about a $40 billion shortfall. Barclays was interested in buying out Lehman, but because of English restrictions, it would need to wait almost a month for shareholder approval. Warren Buffet was called to see if he could put up some cash in the meantime, but he could only promise $5 billion. So, Barclays proposed that the United States government cover
Petrich 6 the deal until Barclays could get approval. Geithner and Paulson, however, had little time to discuss this – AIG was falling fast, and a Merrill deal was fast approaching. Thain met with Lewis again on the morning of the 14th, and agreed to negotiate a total buyout of Merrill by Bank of America. Upon returning to the meetings at the New York Reserve Board, however, he received an offer from Goldman to buy out 9.9% with some other concessions. This was exactly what he had hoped for, and he sent word to his people negotiating at Bank of America to let the Goldman people examine Merrill’s books. Eventually Bank of America won out, with an extraordinary offer, and at 1 AM the next day, the papers were signed: the firewall was set. Meanwhile, billionaire Flowers and German insurance company Allianz had approached AIG with an offer to buy AIG for the price of $2 per share, but were laughed out of the office at the low-ball offer (AIG was trading for $12 per share). With the Merrill issue being settled, Geithner and Cox (chairman of the Securities and Exchange Commission) advised Lehman to file for bankruptcy, as a Barclays deal would not go through, and the government would not intervene. The board of directors agreed, and so within an hour of each other, Lehman had filed for bankruptcy, and Merrill was bought by Bank of America. Though the firewall was set, Lehman’s failure affected money market funds, as their assets in Lehman fell to zero, compounding investor worries. Suddenly, AIG (with investments in money market funds) was floundering with no offers for purchase remaining, and billions of cash necessary to prevent bankruptcy. This time, the government stepped in, with Paulson and Bernanke loaning an incredible $85 billion to AIG at a high interest rate, under an emergency provision in the Federal Reserve Board charter. This move, however, did not save the markets. As Lehman’s assets were frozen, investors made runs on Goldman Sachs and Morgan Stanley, putting their money into nearriskless United States Treasury bonds, whose rates fell below 0%. This means that people were
Petrich 7 willing to invest their money at a guaranteed small loss than take any risk whatsoever. A true crisis was at hand; one which would soon affect Main Street. Congressional action would be necessary for the Treasury to insure money market funds, yet another unprecedented step deemed necessary by Paulson and Bernanke. After getting President Bush on board, it was not difficult to get Senator Reid and Congresswoman Pelosi committed, and $700 billion was allotted to the Treasury after lengthy debate to finance troubled assets for mortgage-based and other securities. In addition, the SEC decided to ban short-selling on nearly 800 financial stocks in order to protect Wall Street from degrading speculation. The panic finally ended as Bernanke and Paulson decided to inject the $700 billion directly into banks, and encouraging the combination of investment and consumer banking. A recession followed the panic of September 2008, which led to unemployment rates of near 10%. However, Bernanke and Paulson maintain that they did what was right; though they did not realize the effect the collapse of Lehman would have, they maintain that it was inevitable, and that their later efforts prevented a second Great Depression. If the Federal Reserve Board and Treasury Department are not to blame, then who is? Some have accused to the quants. The Case against the Quants In 2000, David X. Li published a paper in The Journal of Fixed Income, called “On Default Correlation: A Copula Function Approach.” In this article, he outlined his Gaussian copula function, which was designed to correlate risks of default in any two mortgages anywhere by outputting a single, constant, correlation number. Prior to publication, investors had to look through years of historical data in order to analyze correlations between prices on real estate. The correlation between houses next to each other might be easy to compare, but a suburban house near Los Angeles could not reliably be compared to a vacation home in Maine in terms of fluctuation in price. This lack of data kept the market for mortgage-based securities down, as it
Petrich 8 was too difficult to assess risk. The markets for mortgage-based securities are called credit default swaps or CDS, and, until Li’s function, they remained small. Li’s Gaussian copula function took away the necessity for analyzing proven historical correlation between default rates. Instead, his model drew on past prices of CDS. He assumed that the markets had priced risk accurately, so basing future prices on previous prices would make sense. The problem with this is that all previous prices on credit default swaps were from the years of the housing boom, in which prices soared country-wide. Correlation was nearly always positive, so collections of mortgage based securities were often given higher ratings for their lower risks. Unfortunately, correlation is not a constant; in different economic and political settings, the same two assets can do wildly different things. This aspect was disregarded however, and Li’s function was used to drive the CDS market from one of billions of dollars to over $62 trillion, almost all of it based on the function’s faulty risk-predictions. Without a lengthy explanation of the CDS markets and correlation factors, suffice it to say that the change in home appreciation from positive to negative caused thousands of investments to plummet, as more people defaulted on their loans, making the credit default swaps worthless. It was these swaps that played a major factor in the bankruptcy of Lehman Brothers, as discussed earlier, and so the work of at least one quant, David X. Li, caused the financial crisis. Why the Quants are Innocent Though it was a quant’s model that led to wild over speculation of mortgage based securities and thus the financial crisis, it was not the quants who abused the models. Li said of his own formula, “The most dangerous part is when people believe everything coming out of it” (Salmon 112). Just as we do not blame the gun maker for a person’s murder, we should not blame the quants for the financial crisis. The model was given to traders and CEOs with the
Petrich 9 conditions under which it could be reliably used. The assumptions were made clear, yet the people who did not sufficiently understand the model abused it anyway. Mathematics still deserves a large role in the financial sector as it has helped streamline the calculation of risk and enable multi-trillion dollar markets. Action needs to be taken, however, to make sure that mathematical models are not abused, and that is something that the SEC, Federal Reserve Board, Department of the Treasury and New York Reserve Bank need to watch over. If Quants did not cause the financial crisis, then who did? Though a large number of factors contributed to the failure of mortgage-based securities, it is clear that the majority of the CEOs on Wall Street were utterly incompetent. They became too detached from day-to-day options, residing in their multi-million dollar offices and wallowing in enormous salaries. They should have realized, as any economics student would have, that housing prices cannot increase indefinitely, and that every bubble must eventually burst. It is probably for this reason that there are few of the same CEOs left at the major Wall Street banks, including AIG, Lehman Brothers, Merrill Lynch, and Goldman Sachs. The Future of Mathematical Finance Quants will continue to work on Wall Street in the same capacity as they always have, though traders will probably look at their models more warily, and listen to the assumptions more carefully. New models will be developed to price securities more accurately, until one day the markets will be modeled almost perfectly. Crises will still occur, as even a perfect mathematical model could be abused by greedy investors, but the mathematics will become more refined every year, until the markets are modeled almost flawlessly. As this transition occurs, quants will start spreading to other fields, like systems biology and quantitative medicine, applying the tools learned from the financial markets to even more random systems, much as the pioneering quants applied the models of physics to finance.
Petrich 10 In the meantime, quants need to regain their respect on Wall Street, partially lost because of abused models. This is necessary for the health of the global economy. In the age of billiontrade days, old-fashioned theories and hunches must be replaced by hard quantitative logic, which is only possible with mathematics. Markets are not getting any simpler, and with the proper integration of mathematics, this can be a good thing. It could even lead to entirely new types of markets, as we are beginning to see with green technologies and carbon “cap-and-trade” ideas. An economically feasible solution to climate change is vital to the health of the planet, and when quants provide this, they will save the world.
Works Consulted Bernanke, Ben S. "THE MORTGAGE MELTDOWN, THE ECONOMY, AND PUBLIC POLICY." The B.E. Journal of Economic Analysis & Policy (Symposium) 9.3 (2009): Article-2. Print. Primary source by Federal Reserve Board Chairman about how mortgage based securities work, and what the future holds after the financial crisis. Black, Fischer, and Myron Scholes. "The Valuation of Options and Corporate Liabilities." Journal of Political Economy 81 (1973): 637-54. Print. No paper dealing with mathematical methods in finance would be complete without a knowledge of the classic paper written by Black and Scholes, setting off the quant revolution. Cassidy, John. "Annals of Economics - Rational Irrationality." The New Yorker 5 Oct. 2009: 3035. Print. This article describes the reason for uncooperative relationships between Wall Street firms by drawing a parallel to Game Theory's Prisoner's Dilemma and the Millennium Bridge in London. "'Dream Team' Discusses Financial Engineering." Columbia Engineering News Fall (2009). The Fu Foundation School of Engineering and Applied Science. Columbia University. Web. <http://engineering.columbia.edu/web/newsletter/spring_2009/%E2%80%9Cdream_team %E2%80%9D_discusses_financial_engineering>. This source was used for part of the future section, as it contains the opinions of some of the greatest quants of all time, including Robert Merton, recipient of the Nobel Prize for his work with the BlackScholes equation. Gross, Daniel. "The Real ?Green? Innovation." Newsweek 20 Apr. 2009. Newsweek. 10 Apr. 2009. Web. 12 Nov. 2009.
Petrich 12 Joshi, Mark. "The Mathematics of Money." The Princeton Companion to Mathematics. Ed. Timothy Gowers. Princeton: Princeton UP, 2008. 910-16. Print. This is an excellent introduction to the use of mathematics in finance for the layman or mathematician. It was used extensively in writing the introduction, history, and future sections. Lindsey, Richard R., and Barry Schachter, eds. How I Became a Quant: Insights from 25 of Wall Street's Elite. Hoboken: John Wiley & Sons, Inc, 2007. Print. This book provided excellent background on the careers of several different successful quants working on Wall Street. The introduction was invaluable as a source for history of the field and technical definitions. Salmon, Felix. "Formula for Disaster." Wired Mar. 2009: 76+. Print. This source heavily criticizes quants on Wall Street, blaming them for the financial crisis. It explains in depth David X. Li's Gaussian copula function as well, and provided most of my information for the case against quantitative mathematics. Stewart, James B. "Eight Days." The New Yorker 21 Sept. 2009: 59-81. Print. This article provides extensive detail on the events of the financial crisis in September of 2009. The author interviewed almost all of the major Wall Street executives and regulators, as well as experts in economics to provide information in hindsight.
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