# Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

## Teaching finance the hard way

December 29, 2008

Posted by on I was recently asked for my views on whether and how we should

change the way we teach finance after all that we have seen in 2007

and 2008. Some of my thoughts are as follows.

- Quantitative models based on non normal fat tailed distributions

with non linear dependence structures (copulas) are hard, but we must

not shirk hard mathematics. It is much easier to talk about 2.33

standard deviations and simple correlations, but much of this is a

delusion when applied to financial markets. It is even easier to adopt

the viewpoint of some of Taleb’s followers that models are

useless, but this is the path of nihilism. I think there is no place

in finance teaching either for delusions or for nihilism. It is the

creativity and subtlety of Mandelbrot that attracts me. - Fat tailed distributions also required us to re-examine the use of

historical data in financial modeling and simulation. Five or even

ten years of historical data tell us very little about the true

distribution if it is fat tailed. A lot of what happened during 2008

would have appeared ex ante impossible to anyone looking at several

years or even a few decades of history. But one can see many parallels

if one is prepared to go back several decades or a few

centuries. Since we do not usually have high quality data going that

far back, the implication is that historical simulation should be

de-emphasized in favour of robust models that are qualitatively

consistent with decades if not centuries of historical experience and

extrapolate far beyond recent experience. I have long been fond of

saying that one must approach the study of finance with Ito’s

lemma in one hand and Kindleberger’s book in the other. Needless

to say, the version of Ito’s lemma that I like to have in one

hand is the one for semimartingales and not the one for Brownian

motion alone! - There is a need to shift from behavioural traits to hard nosed

rational models. It is amazing but true that so much of what happened

during 2007 and 2008 can be explained as the rational response of

economic actors to altered fundamentals. I think that the crisis has

taught us that finance is not a branch of psychology. For example,

reliance on credit history (FICO scores) during credit appraisal

assumes that default is a behavioural trait that can be measured using

past track record. Rational models (Merton style models) assume that

people default when it is rational to do so and focuses attention on

modeling the fundamentals (for example home prices). Clearly lenders

would have been much better relying on rational models rather than

presumed behavioural traits. Unfortunately, during the lending boom,

behavioural models held sway and these were supported by the short

historical time series data that was then available. - Much of modern finance deviated too far from its micro foundations

in terms of well defined fundamentals. Derivative models allow us to

compute implied volatility and implied correlations (and if necessary

the entire implied risk neutral distribution) and start valuing

anything without any regard to fundamentals at all. Models then become

over calibrated to markets and under grounded in fundamentals. For

example, quite often derivative textbooks and courses do not encourage

us to ask questions like: what is the fair value of an option if we

assume that the underlying is 10% overvalued in the marketplace. Just

as finance is not a branch of psychology, it is not a branch of

mathematics either. - We need to teach more about the limits to arbitrage not in terms of

behavioural finance, but in terms of well specified market micro

structure with proper attention paid to transaction costs, leverage,

and collateral requirements. The important stream of literature

linking funding liquidity and market liquidity needs to be part of the

core courses in financial markets. - Perhaps we teach too much of ephemeral institutional detail. A lot of

the details which we taught to our students during the last 3-5 years

has been obsoleted by changes in the market structure. Investment

banks are gone, the Libor market is barely recognizable and risk free

government paper is no longer risk free. When we are preparing

students for a career and not for their first job, we must emphasize

functions and not institutions; concepts and not context.

In short, I believe finance teaching particularly in MBA courses

during the early and mid 2000s became too soft and easy to cater

to the needs of an ever growing body of students who sought a career

in finance without any real aptitude for the subject. We dumbed

finance down for the mass market. The time has come to go back to

teaching finance the hard way – and perhaps there will be fewer

students in the classroom.

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