Mon, 29 Dec 2008

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.

Posted at 14:39 on Mon, 29 Dec 2008     13 comments     permanent link

Comments...

Sahil wrote on Mon, 29 Dec 2008 15:42

Re: Teaching finance the hard way

Dear Professor,

This is very well written. The academic committees at the IIMs would do well to take this piece into account when discussing the relevance, and I would go as far as to say - the rigor of the current finance curriculum.

I remember when we were taught derivatives, the portions on Ito's lemma and martingales were skipped completely. Also - when a few of us raised questions on fat tailed distributions and non-linear dependence structures, we were informed that these were far too sophisticated for a basic class on financial derivatives - in essence, we were advised that the marginal effort needed to understand models based on fat-tailed distributions was not worth it: in retrospect, a dangerous piece of advice.

The other issue from a student's perspective is that there are few (very, very few) instructors capable of teaching advanced classes in finance. As students, the number of times one is let down by teachers not only limits understanding but also dampens curiosity.

But then, as you point out, these are strange times. Perhaps we have reached a tipping point.

It would be especially good to have your thoughts on the second issue, as someone who has taught finance for so long.

Regards.

• Gaurav wrote on Mon, 29 Dec 2008 18:18

  Re: Re: Teaching finance the hard way
  

  Dear Sir,

  IIM-A should introduce a course on Hyman Minsky. "Stabilizing an Unstable Economy" is much more accurate than Samuelson - at least this time around in the business cycle.

  Regards.

  • Sahil wrote on Wed, 31 Dec 2008 11:52

    Re: Re: Re: Teaching finance the hard way
    

    I agree. While I'm not sure the current crisis follows from Minsky's theory of endogenous financial fragility (since the causes here appear to a systematic mis-pricing of risk), a course (or at least a number of sessions) on his work would be instructive.

Sarbvir Singh wrote on Mon, 29 Dec 2008 21:06

Re: Teaching finance the hard way

Dear Prof. Verma,

You have really written a very balanced and insightful piece. I hope that the powers-that-be will take note and incorporate your suggestions.

On a personal note, reading your super blog makes me feel really sorry that I did not have the opportunity to take any of your courses!

Regards,

Sarbvir

Balu Kenchappa wrote on Tue, 30 Dec 2008 10:43

Re: Teaching finance the hard way

I largely agree with Prof. Verma. The problem remains to be that of 'how to ensure right mix of behavourial issues, long range quality data and skillful factoring of then prevailing macro-economic environment' in to the modelling exercise. History suggests that it is not so easy to develop such a robust models for on the field application, leave alone for class room experimentation. The real challenge lies in ensuring that the model is contemporaneous with back testing abilities and success. While I agree with Prof. Verma when he says that "we must emphasize functions and not institutions; concepts and not context", I do get an impression that finance case studies prepared at management schools has lot of bias in favour of institutions and context. It appears to me that the writers of the case studies focus more on 'practice' than 'principles'.

Balu Kenchappa wrote on Tue, 30 Dec 2008 13:22

Re: Teaching finance the hard way

I largely agree with Prof. Verma. The problem remains to be that of 'how to ensure right mix of behavourial issues, long range quality data and skillful factoring of then prevailing macro-economic environment' in to the modelling exercise. History suggests that it is not so easy to develop such a robust models for on the field application, leave alone for class room experimentation. The real challenge lies in ensuring that the model is contemporaneous with back testing abilities and success. While I agree with Prof. Verma when he says that "we must emphasize functions and not institutions; concepts and not context", I do get an impression that finance case studies prepared at management schools has lot of bias in favour of institutions and context. It appears to me that the writers of the case studies focus more on 'practice' than 'principles'.

• Apurv Dhingra wrote on Wed, 31 Dec 2008 12:00

  Re: Re: Teaching finance the hard way
  

  I agree with Varma Sir and Balu Sir.Case studies need to be made more generic and curriculum needs to be redesigned so that we focus mode on fundamentals of finance rather than a few institutions.

Siddharth Surana wrote on Wed, 31 Dec 2008 12:38

Re: Teaching finance the hard way

Very well put Prof. When things are going good, people tend to get euphoric and assume that this'll last forever. Finance is not a 'soft' area like H.R. or O.B. it's a highly specialized field and that's how it should be.

Hemchand J wrote on Wed, 31 Dec 2008 20:21

Re: Teaching finance the hard way

Sir, I read your writing with great interest. I agree with your views on the infalliability of models but history has also taught us that modelling is not everything. There still remain certain areas of finance which have to be mastered the hard way. Which cannot be taught by brilliant mathematicians. There are certain areas (like valuation of assets ) which cannot be totally quantified and it will be wrong to teach students financial modelling alone neglecting the tenets of banking.The crisis of 2008 has taught us to include the risk of uncertainty in our list and not to forget the spirit of finance and human factor while dabbling in banking.

Finance Guy wrote on Thu, 01 Jan 2009 11:28

Re: Teaching finance the hard way

Fairly well put but I disagree with your extreme emphasis on modeling and reliance on historical data. Those of us who work in the industry that modeling and data can only get you so far..Ultimately, we are driven by gut feel and psychology and that has not and will never change.

However, the thing that I take greater issue with you in your post is : "We dumbed finance down for the mass market"..If as a professor, you cannot explain your concepts to the mass market, then I don't believe you are that great a professor quite honestly. I have had the benefit of being taught by esteemed professors in both India and the US. And in my honest opinion, the biggest difference was the attitude of professors towards their students. Indian professors live in their own shell of elitism and have a very hard time connecting with their students. The students who come out of such classes tend to know the class well but can rarely apply those concepts in a more extensive sense. Consequently, we as a country don't produce "mass leaders" the way we need to..

• Hemchand J wrote on Thu, 01 Jan 2009 17:44

  Re: Re: Teaching finance the hard way
  

  Very well put. I was indicating your thoughts in a mild manner. You certainly appear to be an industry person and the GUT feel about your investments is more weighty than all models. We have been taught to go by Character, Capacity and Creditworthiness of the borrower, in that order and now as the bigwigs of private sector banking are admitting, ' it is back to basics'. During my stint as a Professor of Finance, after leaving the industry, interaction with the students and taking out the boredom of modelling is also very important while teaching finance, though no doubt it is not a 'light' subject.

  Venkatesh wrote on Sun, 01 Feb 2009 07:19

  Re: Re: Teaching finance the hard way
  

  Hi Finance Guy, I have taken a couple of courses offered by Prof.Varma and they were some of the best lectures I had ever atteded. I think it is important for the students to put in the required hard work to get value out of their teachers. How can the "mass market" understand derivatives pricing, if they do not understand say stochastic calculus. I think making very general statements like Indian professors all behave or think in a particular manner , does great disservice to some of the most extraordinary teachers in India. And remember, these gentlemen get paid a fraction of what their counterparts in the U.S gets paid.

Harsha wrote on Fri, 02 Jan 2009 04:56

Re: Teaching finance the hard way

Dr Verma,

Although the concerns raised are valid,I agree to a large extent with Finance Guy.I have a masters degree in financial engineering and i have studied in-depth all the mathematics you mention.But it was quite a revelation when I started trading derivatives in my first job.Even if you model fat tails,liquidity effects etc,it is always a struggle between keeping the model simple enough to be intuitive and fitting as broad a range of market instruments as possible.Nothing can replace comprehensive knowledge of markets,institutions and players.Financial models merely provide a way of thinking about valuation and hedging issues.It is dangerous to think of them as anything else.