Friday, April 10, 2009

Financial Engineers as Bridge Architects

Economics is a new science. Financial engineering is an even newer science.

Humankind's earliest bridges were flimsy. Over time, they got better and better, but sometimes bridges collapse.

If a wood bridge collapses, does it mean that the science of bridge building is too dangerous? Does it mean that we should abandon bridges because sometimes bridges collapse? No, because collapses are relatively rare and before the bridge collapses, it serves a lot of good.

Now let us say a "fat tail" event occurs. Architects for a bridge in the Bay Area put a lot of effort into ensuring that the bridge can withstand an earthquake that is 9.0 on the Richter Scale. A 10.0 earth quake has never been recorded and it would cost $10B to make the bridge that resilient. Should the Mayor of San Francisco raise taxes, cut teachers' salaries, etc. in order to make the bridge 10.0 safe?

Then imagine that one day a 10.0 earth quake hits. A 10.0 quake has never been recorded in history - are the architects to blame? Is the mayor to blame?

Or is maybe no one to blame. Science is not perfect, but continuously improves. The financial sciences are in their infancy and need to be nurtured and incubated rather than left exposed like weak Spartan babies.

[Note 20-April-09: I have found another article ("Don't Blame the Quants" - Forbes)that uses this analogy; it was written in Oct 08 by Steven Shreve, the Orion Hoch professor of mathematical sciences at Carnegie Mellon University:

"It is easy under these circumstances to point an accusing finger at the "quants" on Wall Street, that cadre of mathematics and physics Ph.D.s who crunch numbers in esoteric models. Without the quants, the complicated mortgage-backed securities that fueled the housing bubble and led to the freezing of credit might not have been created. The models used by the quants determine the prices of those securities and steer the traders who make markets in them. Without this guidance, the banks might not have touched them in the first place. To prevent a recurrence of financial crises, some call for a return to a simpler time, before derivative securities and the quants who analyze them--a time when investors bought stocks and bonds and little else.

Such complaints miss the point. When a bridge collapses, no one demands the abolition of civil engineering. One first determines if faulty engineering or shoddy construction caused the collapse. If engineering is to blame, the solution is better--not less--engineering. Furthermore, it would be preposterous to replace the bridge with a slower, less efficient ferry rather than to rebuild the bridge and overcome the obstacle."]

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