Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Teaching finance the hard way

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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