The Hindu Business Line : RIP: Modern theory of finance

When a study of the recent collapse of American and international financial markets is undertaken it is bound to unearth the role of a most unlikely and academically credentialed participant. Yes, we are talking about the theory of modern finance and its sub-branches that have shaped financial thinking for the past 40 years.

When investment banks, commercial banks and insurance companies in the financial services sector began to pile on huge market risks in pricing, volume and portfolio of investments, they were able to point to their financial models for risk calculation and its subsequent elimination. All they had to do was to say ‘we have a bunch of rocket scientists who have crunched the numbers employing portfolio theory and value at risk models to arrive at our portfolio’s resultant risk which is well within acceptable limits,’ and their interlocutor was mollified.

Backed by Nobel prizes in economics, the modern finance theory has been a willing and enormously credible participant in the events leading up to the meltdown.

Now, if all players had used the academically blessed financial models and yet have landed themselves and the rest of the financial markets in a complete collapse, it stands to reason that these models and the theory of modern finance which provided their intellectual foundations need to be examined.

What do critics of modern finance theory have to say about the inadequacy of such models? There are several criticisms, the chief among them being put forth by Mandelbrot, Nassim Taleb and others on the wrong representation of financial markets.

Criticism of modern theory

Modern finance is built upon the assumption that the behaviour of stock prices and that of other risk-prone financial assets follow normal or Gaussian distribution and correlating a specific stock’s price with that of the rest of the market determines how risky it is vis a vis the market. Thus ‘beta’ is a valid representation of the risk profile of a stock according to this theory, the standard weapon in the mutual fund manager’s tool box.

Wait a minute, the critics seem to be saying, normal distribution does not capture the price behaviour of risky assets, particularly when the variation is several times above and below the norm, as in boom or bust periods; that is the ‘fat tail’ phenomena when prices go through the roof or under the basement. Therefore, any theory or model built on such false assumptions would only lead to wrong results, namely a spectacular collapse of the markets while the participants are lulled into thinking they are somehow ‘controlling their risks’.

To quote Pablo Triana, one of the stern critics of modern finance, “The main factor behind the unleashing of the crisis was the widespread use of flawed quantitative/theoretical methodology by financial institutions, with the enthusiastic blessing and encouragement of regulators and the academic financial economics establishment. We can highlight at least two key culprits: the Value at Risk (VaR) model for “measuring” risk and setting capital charges, and the Gaussian Copula model for valuing and rating Sub-prime Collateralised Debt Obligations; by abiding by those two scions of quantitative finance, the financial industry guaranteed that never before was risk so badly anticipated and valuations and credit ratings so hopelessly off-base. The inevitable end result was massively leveraged exposures to impossibly overrated toxic securities, which brought the system down as the underlying mortgage market turned sour”.

There are, of course, two other contributory but equally flawed assumptions on which rest the modern theory. The perfect market hypothesis which talks about the financial market being efficient processors of all available information has always been suspect among the practitioners, namely traders in the market. While the theory says that the markets cannot be timed, that is no one can have an advantage over others by virtue of better information, traders systematically exploit market imperfections and make a living out of timing stocks. In this age of instant communications and global financial markets, even a two-minute window when the market is imperfect represents opportunities for timing the market for profit.

The other assumption which runs right through the financial economics literature is about man being rational, and he being able to maximise his gains by making logical choices out of several options available to him. Many field experiments have shown that such is not the case: even among graduate students of business, a good proportion of them are unable to distinguish between equally beneficial outcomes and perhaps are clouded by their tendency to avoid losses/ pain. Add this to the ‘endowment effect’ when people value what they possess more highly than what they do not have with them yet, you can point to many seemingly irrational behaviour even among sophisticated investors. The rational behaviour assumption wears thin when one observes several hedge funds and professional traders among the losers in the colossal Madoff scam.

Behavioural theory on a comeback?

In the aftermath of the financial meltdown, the academic establishment will have to do some soul searching though many may have invested their entire careers on chasing wrong premises. One can predict the resurgence of the behavioural theory of finance and economics, which has so far been relegated to the fringes by vested interests. There is even a move to caution the Nobel Committee to go easy on Nobel awards for economics on suspect theories as they have done in the past. To quote Pablo Triana yet again, “The unhealthy obsession with assigning precise measurements to that which is not amenable to concrete quantification has gotten us in enough trouble already; by relentlessly and consistently embracing and promoting theories that promise precision and concreteness (yet are built upon unremittingly flawed foundations) the Nobel Committee has led us down the path of painful deleteriousness.” Strong words indeed on what is after all an academic debate about theories. Replacing the quantitative theory of finance is not as easy as it looks since it will refuse to die a quiet death; thousands of graduates have been fed on it and countless academic careers in finance are built upon its validity. There is going to be a battle for prominence among the nebulous newcomers and the solid looking but mortally flawed old guard. It would have been exciting to watch from the sidelines, but for the losses one had to suffer following the tenets of modern finance.

(The writer is a management consultant and heads Alter-Ego Consulting; he can be reached at avrammohan@yahoo.com)

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RIP: Modern theory of finance