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Financial engineering has provided innumerable lucrative opportunities for otherwise indigent mathematicians Nevertheless the turbulence in the bond markets in the last couple of months, at a time when the world economy’s prospects seemed set fair, have exposed a guilty secret of the financial engineering profession: its methods don’t work.
First area of failure is liquidity. Theoretically, if financial engineers design ever fancier artificial securities and derivatives, but everybody uses the same mathematical models to value them, there is no reason why an active market should not operate in the securities, at whatever price the models direct.
In practice this only works in calm markets. In times of market turbulence, when doubts arise about either the mathematical models themselves or the underlying assets from which value is derived, the true value of these artificial assets becomes thoroughly unclear. Buyers assess their value at the lowest possible level, and refuse to increase their exposure to a sector that suddenly appears dangerous, while sellers attempt to get out of the business altogether.
Accounting methodology had problems, which allowed assets to be valued based on the theoretical prices produced by the mathematical model.
Banks and investment banks have adopted a number of approaches to the problem of their balance sheets’ subprime mortgage-related assets.
The second problem with financial engineering products that the whizzes involved have failed to solve is their valuation. Simple derivatives such as interest rate swaps in currencies with liquid government bond markets and forward Treasury futures can be valued by mathematical techniques that are simple and fairly robust; thus market participants can agree on the underlying value of these assets even when markets are turbulent.
The problem becomes much more difficult when a financially engineered product involves an embedded option, or like asset backed commercial paper is of markedly different liquidity from its underlying asset.
The standard option valuation models do not work at all well for out-of-the-money options, because they assume the randomness of future events that are in reality not random but unknown. The phenomenon of volatility “smile” in option pricing, whereby the implied volatility of out-of-the-money options is considerably higher than that of at-the-money options, is a sign that the underlying theory, which postulates constant volatility over the full range of strike prices, is hopelessly flawed.
Some trading strategies are particularly attractive to market participants because they pull income up-front, enabling participants to recognize larger profits (and presumably receive larger bonuses) in the current year while deferring losses into future periods when they may have left the group.
The profitability of financial engineering to its practitioners is unquestionable. Its profitability to the institutions that employ those practitioners may have been almost equally solid in the past, but could be undermined in the future by a period of market turbulence that produces gigantic write-offs
Financial engineering’s benefit to the global economy is questionable at best and the increases it has produced in the financial services sector’s share of global output may have been mere successful rent seeking.
In the long run, less opulent compensation for financial engineers, more aggressive audit and supervision policies for financial institutions’ engineered assets and a healthy cynicism about financial engineering in general and that will likely prove a positive development.
First area of failure is liquidity. Theoretically, if financial engineers design ever fancier artificial securities and derivatives, but everybody uses the same mathematical models to value them, there is no reason why an active market should not operate in the securities, at whatever price the models direct.
In practice this only works in calm markets. In times of market turbulence, when doubts arise about either the mathematical models themselves or the underlying assets from which value is derived, the true value of these artificial assets becomes thoroughly unclear. Buyers assess their value at the lowest possible level, and refuse to increase their exposure to a sector that suddenly appears dangerous, while sellers attempt to get out of the business altogether.
Accounting methodology had problems, which allowed assets to be valued based on the theoretical prices produced by the mathematical model.
Banks and investment banks have adopted a number of approaches to the problem of their balance sheets’ subprime mortgage-related assets.
The second problem with financial engineering products that the whizzes involved have failed to solve is their valuation. Simple derivatives such as interest rate swaps in currencies with liquid government bond markets and forward Treasury futures can be valued by mathematical techniques that are simple and fairly robust; thus market participants can agree on the underlying value of these assets even when markets are turbulent.
The problem becomes much more difficult when a financially engineered product involves an embedded option, or like asset backed commercial paper is of markedly different liquidity from its underlying asset.
The standard option valuation models do not work at all well for out-of-the-money options, because they assume the randomness of future events that are in reality not random but unknown. The phenomenon of volatility “smile” in option pricing, whereby the implied volatility of out-of-the-money options is considerably higher than that of at-the-money options, is a sign that the underlying theory, which postulates constant volatility over the full range of strike prices, is hopelessly flawed.
Some trading strategies are particularly attractive to market participants because they pull income up-front, enabling participants to recognize larger profits (and presumably receive larger bonuses) in the current year while deferring losses into future periods when they may have left the group.
The profitability of financial engineering to its practitioners is unquestionable. Its profitability to the institutions that employ those practitioners may have been almost equally solid in the past, but could be undermined in the future by a period of market turbulence that produces gigantic write-offs
Financial engineering’s benefit to the global economy is questionable at best and the increases it has produced in the financial services sector’s share of global output may have been mere successful rent seeking.
In the long run, less opulent compensation for financial engineers, more aggressive audit and supervision policies for financial institutions’ engineered assets and a healthy cynicism about financial engineering in general and that will likely prove a positive development.
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1 comments on "Why Financial Engineering Doesn’t Work"
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Commented by
Mathew Cherian, Research Associate/Analyst, Western Michigan University
| 04 26 2009 19:05:46 +0000
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