Don Mango

American Re-Insurance

Don Mango

American Re-Insurance

Unsolved ProblemsUnsolved Problemsin Financial Sciencein Financial ScienceUnsolved ProblemsUnsolved Problemsin Financial Sciencein Financial Science

OutlineOutlineOutlineOutline

What is Financial Science? Data Capital Treatment Content-less volatility Market-sensitive risk measures Value versus Price Convergence in Modeling Adaptive Systems

What is Financial Science? Data Capital Treatment Content-less volatility Market-sensitive risk measures Value versus Price Convergence in Modeling Adaptive Systems

What is Financial Science?What is Financial Science?What is Financial Science?What is Financial Science?

Converging field with roots in finance, financial economics, economics, financial engineering, insurance, and actuarial science.

Study of contingent financial activities (loans, insurance policies, bonds, derivatives, stocks), and their structure, valuation, sale, exchange, accumulation, and interaction.

Converging field with roots in finance, financial economics, economics, financial engineering, insurance, and actuarial science.

Study of contingent financial activities (loans, insurance policies, bonds, derivatives, stocks), and their structure, valuation, sale, exchange, accumulation, and interaction.

DataDataDataData

Sequence for a “regular” science (e.g., Chemistry):Hypothesis and predictionsExperimental designExperimentData collectionData analysisConclusions and refinements

Bottom line: lot of thought and effort before a single number shows up

Sequence for a “regular” science (e.g., Chemistry):Hypothesis and predictionsExperimental designExperimentData collectionData analysisConclusions and refinements

Bottom line: lot of thought and effort before a single number shows up

DataDataDataData

Sequence for financial science:Data collection Data analysisHypothesis and predictions?Conclusions and refinements?

We got numbers, oh do we got numbers

Experiments are “emergent”

Sequence for financial science:Data collection Data analysisHypothesis and predictions?Conclusions and refinements?

We got numbers, oh do we got numbers

Experiments are “emergent”

DataDataDataData

Experimental design – forget it Experiment = the market itself! F.A. Hayek, “Competition as a

Discovery Procedure”Competition is a parallel process of

experimentation and hypothesis testing

Experimental design – forget it Experiment = the market itself! F.A. Hayek, “Competition as a

Discovery Procedure”Competition is a parallel process of

experimentation and hypothesis testing

Content-less VolatilityContent-less VolatilityContent-less VolatilityContent-less Volatility

J. Doyne Farmer (Santa Fe Institute) and Shareen Joshi, “The Price Dynamics of Common Trading Strategies”Interaction of agents’ strategies induces

volatilityCan be mutually reinforcing (negative

feedback)The volatility is symptomatic of our own

actions, not fundamental to the assets. Can happen “without innovations”

J. Doyne Farmer (Santa Fe Institute) and Shareen Joshi, “The Price Dynamics of Common Trading Strategies”Interaction of agents’ strategies induces

volatilityCan be mutually reinforcing (negative

feedback)The volatility is symptomatic of our own

actions, not fundamental to the assets. Can happen “without innovations”

Market-Sensitive Risk Market-Sensitive Risk MeasuresMeasuresMarket-Sensitive Risk Market-Sensitive Risk MeasuresMeasures Avinash Persaud, State Street

Bank“Sending the Herd Off the Cliff Edge:

The Disturbing Interaction Between Herding and Market-Sensitive Risk Management Practices”

Institute of International Finance 2000 Essay Contest Winner

One of the most important works in recent literature

Available free at www.erisk.com/reference/archive/persaud.pdf

Avinash Persaud, State Street Bank

“Sending the Herd Off the Cliff Edge: The Disturbing Interaction Between Herding and Market-Sensitive Risk Management Practices”

Institute of International Finance 2000 Essay Contest Winner

One of the most important works in recent literature

Available free at www.erisk.com/reference/archive/persaud.pdf

Market-Sensitive Risk Market-Sensitive Risk MeasuresMeasuresMarket-Sensitive Risk Market-Sensitive Risk MeasuresMeasures In short run:

Markets find it hard to distinguish between good and unsustainable

Market participants herdContagion is common

In a herding environment:Tighter market-sensitive risk management

systems and more transparency makes markets less stable and more prone to crisis

Volatility contagion across unforeseen dimensions

In short run:Markets find it hard to distinguish between

good and unsustainableMarket participants herdContagion is common

In a herding environment:Tighter market-sensitive risk management

systems and more transparency makes markets less stable and more prone to crisis

Volatility contagion across unforeseen dimensions

Value versus PriceValue versus PriceValue versus PriceValue versus Price

Imprecise communication uses them interchangeably

Value requiresInterpretation, FiltersPreferences, JudgmentExpectations, TrendsModelsContext of your situation, existing

portfolio, strategy

Imprecise communication uses them interchangeably

Value requiresInterpretation, FiltersPreferences, JudgmentExpectations, TrendsModelsContext of your situation, existing

portfolio, strategy

Value versus PriceValue versus PriceValue versus PriceValue versus Price

Market Price = A record of a transaction… …which is an agreement of

acceptable value in exchange……between two parties who

e-VALUE-ate the transactionThe presence of the market means

that some of that evaluation process takes into consideration the possible future price

Market Price = A record of a transaction… …which is an agreement of

acceptable value in exchange……between two parties who

e-VALUE-ate the transactionThe presence of the market means

that some of that evaluation process takes into consideration the possible future price

Convergence in ModelingConvergence in ModelingConvergence in ModelingConvergence in Modeling

No more normal distributions Not just measure change or value

transformDr. Novosyolov’s paperAn analytic framework that can

express varying opinions Let’s develop a common

structure, then we can argue over parameters!

No more normal distributions Not just measure change or value

transformDr. Novosyolov’s paperAn analytic framework that can

express varying opinions Let’s develop a common

structure, then we can argue over parameters!

Adaptive SystemsAdaptive SystemsAdaptive SystemsAdaptive Systems

Previous paradigm: Rational representative agentEquilibriumAnalytically tractable model

New concepts:Bounded rationalityHeterogeneous agentsComputational solutionEvolution

Previous paradigm: Rational representative agentEquilibriumAnalytically tractable model

New concepts:Bounded rationalityHeterogeneous agentsComputational solutionEvolution

Adaptive SystemsAdaptive SystemsAdaptive SystemsAdaptive Systems

Huge research community in adaptive modeling:Financial marketsWater policySocial sciencesMilitarySee National Academy of Sciences 2001

Sackler Symposium “Adaptive Agents, Intelligence, and Emergent Human Organization: Capturing Complexity through Agent-Based Modeling”

Huge research community in adaptive modeling:Financial marketsWater policySocial sciencesMilitarySee National Academy of Sciences 2001

Sackler Symposium “Adaptive Agents, Intelligence, and Emergent Human Organization: Capturing Complexity through Agent-Based Modeling”

Adaptive SystemsAdaptive SystemsAdaptive SystemsAdaptive Systems

Movement from analytic to computational solutions A valid third alternative “symbol

system” (verbal, mathematical, computational)

Homogeneous representative agents to heterogeneous agents interacting Changes the concept of a “solution”

Movement from analytic to computational solutions A valid third alternative “symbol

system” (verbal, mathematical, computational)

Homogeneous representative agents to heterogeneous agents interacting Changes the concept of a “solution”

Adaptive SystemsAdaptive SystemsAdaptive SystemsAdaptive Systems

This gives us the ability to address:Interaction effectsPolicy changesStrategic interference patterns

It forces us to work together! It changes the nature of the resulting

work productAlmost a new medium

This gives us the ability to address:Interaction effectsPolicy changesStrategic interference patterns

It forces us to work together! It changes the nature of the resulting

work productAlmost a new medium

Adaptive Systems ExamplesAdaptive Systems ExamplesAdaptive Systems ExamplesAdaptive Systems Examples

Trojan MiceGreat introduction to the conceptswww.trojanmice.com

Trojan MiceGreat introduction to the conceptswww.trojanmice.com

Adaptive Systems ExamplesAdaptive Systems ExamplesAdaptive Systems ExamplesAdaptive Systems Examples

NuTech SolutionsSouthwest Airlines cargo handling

proceduresNASDAQ impact of decimalizationSee the Case Studies portion of their

websitewww.nutechsolutions.com

NuTech SolutionsSouthwest Airlines cargo handling

proceduresNASDAQ impact of decimalizationSee the Case Studies portion of their

websitewww.nutechsolutions.com