April 16, 2003

Aground on Scholes of Finance

I am generally receptive to (legal) propositions which involve my receiving sums on the order of my paycheck in exchange for a few days of work. The latest of these came from an editor at Quantitative Finance, and led to my conducting a telephone interview with Myron Scholes and writing a profile of him for QF. (If you don't know who Scholes is, well, read my piece!) Here then a few reflections which it wouldn't have been appropriate to work in to the profile.

1. Scholes is the fifth Nobel laureate I've had a chance to talk to at some length. He's pretty clearly the second most arrogant of the five, though also pretty clearly not the smartest, or even the second smartest. He was understandably completely bored by the idea of discussing the origins of the Black-Scholes formula yet again; other topics interested him more.

2. I did not have the gumption to ask what it felt like to lose several billion dollars over a summer, or if it was true that when LTCM was raising capital, he'd respond to skeptics by saying they'd make money "because of fools like you".

3. Black-Scholes portfolios, combining stock and options in just the right proportions, are supposed to be riskless. This is obviously false. Back in the day, one of my in-laws bought stock in WebVan.com, and has made a return to date of -100%; they're so belly-up I can't give you a link. Could she have hedged away the risks of that stock by suplementing it with the right number of WebVan options? The question answers itself; stuffing the money under her mattress would've had better risk/return properties. Obviously, the problem is that the Black/Scholes/Merton argument assumes the company you're buying stock in will persist indefinitely into the future. Presumably somebody has modified it to include a finite risk of default (though estimating that risk would be tricky at best; see below). But when you make a list of all the over-simplifications that go into deriving the formula, you have to ask whether it relying on it is ever a good idea.

4. When Scholes started talking about how finance needed to embrace non-stationary processes, it was all I could do to not quote D-Squared at him:

"Sir, you can't work out the answer to that question in any statistically reliable manner, sir, because economic processes are nonergodic, sir, because the economy is subject to positive destabilising feedback sir!"
Very well done that pupil. The rest of you, go back to the books and revise.

(For extra credit, reconcile this observation with the fact that chaotic systems are generally ergodic, though "subject to positive destabilising feedback".)

5. Finally, something I was able to hint at in the profile. Scholes seems to seriously think that the growth of finance and financial engineering is supposed to make life in general, and economic decision-making in particular, simpler for non-financiers. If that's the case, well, they're not doing such a good job of it, are they? I can now go to an ATM in Belgium with my American bank card and get euros (his example), which does depend on a very liquid foreign exchange market. Without certain kinds of derivatives on foreign exchange, it would be slightly more expensive for the banks to offer that service, but the magnitude of the expense isn't at all commensurate with the size of the foreign exchange derivative market.

Financial markets (says Scholes, along with the Chicago School which trained him) are the mechanism by which capitalist societies allocate productive resources. It follows that financial markets are economically efficient to the extent that they make better, more productive, allocations than other potentially available mechanisms. (So far so good, says my inner market socialist.) The total profits of the financial sector, in competitive equilibrium, should thus be approximately equal to the waste which would be entailed by using our second-best allocation mechanism. (Larger profits, and it wouldn't pay to use the market; smaller, and they could charge more and get it.) What makes this unbelievable is that the profits of the financial sectors of developed economies have grown dramatically since the 1970s, i.e., at exactly the same time as the great productivity and growth slow-down of those same economies. So assuming the financial sector is fulfilling its role efficiently requires us to believe that the growth slow-down would've been immensely worse without its services. It's hard to tell a plausible story why this should be so, much less back it up with non-tautological evidence. I'm tempted by the idea that around 1975 the financial sector found a new way of extracting rents (perhaps through exploiting some kind of lock-in or switching cost?), but also can't come up with a decent story for that.

The Dismal Science

Posted at April 16, 2003 16:04 | permanent link

Three-Toed Sloth