Observations on the Science of Finance in the Practice of Finance
published: Aug. 13, 2010, recorded: March 2009, views: 5473
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There will be a time “beyond crisis,” asserts Robert C. Merton, who delves into the dense science of derivatives -- a field he has fundamentally shaped -- to explain how the vast global economic collapse has come about, and how financial innovations at the heart of the collapse could also be tools for reconstruction.
Merton uses deceptively simple graphs to show how risk propagated rapidly across financial networks, bringing down financial institutions. While he admits the crisis “is very big and complicated,” Merton boils a piece of it down to the use of put options, a derivative contract that’s been around since the 17th century. This asset-value insurance contract, a guarantee of debt, is the basis for the credit default swaps widely adopted by financial giants in the last few years -- now widely regarded as a primary cause of the meltdown. It turns out, says Merton, that the put “makes risky debt very complicated, and treacherous…”
In these puts, if the value of assets goes down, the guarantee value goes up, so the value of the written insurance is worth more. The value of this guarantee is very sensitive to the movement of the underlying asset. When dealing with puts on the local level, this movement can be tracked and managed more easily. But when financial institutions manipulate bundles of assets (for instance, mortgage-backed securities), the increase in risk proves non-linear. Add some volatility, like the jolts posed by widespread drops in housing prices, and the difference between the decline in asset value and the value of the guarantee becomes enormous -- leading to mountains of debt and felling behemoths like AIG (insurer to lenders).
Yet, Merton counsels not to blame the current crisis on put options, or too much complexity, but rather on incomplete understanding of the models of risk involved. It’s not “bad and incompetent people” who have brought this about (although he admits there are plenty of those) but “a structural issue between financial innovation and crisis.” We’ve essentially built a high speed train for which there’s not yet an appropriate track. We’ve created instruments for manipulating financial risk without a thorough understanding of the underlying engineering.
Derivatives are not going away, says Merton. We need regulators who understand these instruments, and perhaps a sovereign wealth fund intended to “maximize the expected return for risk for people of the U.S.” Merton concludes with “something positive” -- a model of how to “weaken the tradeoff between pursuing comparative advantage vs. efficient risk,” applied to the nation of Taiwan.
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