Rebuilding May 22, 2009 at 9:59 am
There is a lot of comment around at the moment about how broken finance is: here, for instance, is a piece by Pablo Triana. And certainly there are many, many issues that we have no idea how to deal with in practice, including fat tails, autocorrelation, correlation smiles, and hidden systematic risks. These phenomena challenge option pricing models, CDO pricing, basket option pricing, ABS pricing and all sorts of quantitative risk management model.
But, but, but. There are some things that work. The huge push in the 1990s on the behaviour of the yield curve has at least left us with a good idea how to manage single currency swaps books. Vanilla puts and calls can mostly be hedged effectively. Credit derivatives – despite stident claims otherwise – have not caused the end of the world as we know it.
We need then to return to the things we do actually know, and to be very critical about what has worked well, what has worked acceptably, and what has turned out to be unhelpful. Saying the whole edifice of mathematical finance is rotten is just as counterproductive as saying that none of it is. For once, finance theorists need to be disinterested and critical observers of reality rather than cheerleaders (or hooligans). Let’s see what we need to tear down and what is still standing now that the tumult is dying down.