Finance

Financial engineering has been described as the replication of the pay off of  options (as financial instruments who derive their value through an underlying security) through the use of different securities  assets to limit or expand on the downside or upside of the asset itself. However, option pricing theory has a number of assumptions at its heart and options do not hold a symmetrical relationship to their underlying security as a result leading to catastrophic consequences.

Black Monday
The Stock Market crash of 1929 (Black Monday) had its roots in the low interest  environment following World War I when cheap credit enabled Americans to live beyond their means and borrow cheaply to invest in a bullish stock market. These investments then acted as collateral for more borrowing so that in essence the American economy represented a massive asset price bubble with asset prices inflated far beyond their fair values. However, this consistent increase in asset prices could not be sustained as credit started drying up for over leveraged individuals and businesses who were forced to start liquidating their holdings. This led to a massive sell off on the stock market which culminated into a crash of the market itself in October of 1929, sending the world into a deep prolonged recession.

This collapse can be explained by option pricing theory and the replication principle when portfolio managers use assets to replicate the pay off another asset (synthetic instruments). However, replicating an assets pay off does not necessary mean that we limit the downside of our replicating portfolio by the same amount and hence risk return tradeoff changes with replication.

Long Term Capital Management
The Long term capital management fiasco involved a hedge fund of the same name which would play on leverage and hence play around small differences on both sides of the trade of a particular security. However, with the default by Russia in 1998 and the over riding trend for investors to move away from illiquid assets to liquid ones, the hedge fund soon found itself trapped in a liquidity crunch as claims by investors for redemptions mounted. The end result was that the fund was forced to liquidate positions at massive losses and before capital markets would suffer more, the fund was bailed out by the Federal Reserve.

With regard to the application of theory, this disaster has its roots in the misapplication of modern portfolio theory. Hedge fund managers used excessive leverage to earn a modest return whereby the same could have been possible through different avenues with lesser risk. Hence, a mis interpretation of the efficient frontier is seen.

Financial Crisis of 2008
Rising house prices, easy credit terms with special provisions in the initial financing tenure and a welcoming attitude by financial institutions to people with short or no credit histories attracted Americans to take out mortgages. However, a fall in house prices and restricted bank lending to the sector as a result meant that many adjustable rate mortgages could not be refinanced and hence defaults started occurring. However, the impact of these defaults was massive as financial engineering through the use of secularization of these loans and the existence of credit default swaps to hedge against the bankruptcy of these investment vehicles without counter parties re insuring themselves meant that the impact on financial institutions holding these sub standard securities was so large that the whole capital base of some financial institutions was wiped out leading to a massive loss of confidence in the economy.

The lack of mark to market requirements for these assets complicated matters as investors were never really aware of the true value of their investments in these highly structured products and hence mean variance analysis could not return any respectable measure of risk. At the same time, the lack of reinsurance against counter party risks meant that the whole idea of hedging oneself from portfolio losses was neglected.

Best Practices Proposed
Mr Markovitz has proposed that investors should be vary of taking positions in a derivative instrument if they do not understand the dynamics of derivatives themselves while at the same time making note of leverage levels and not letting them go out of hand. Lastly, investors should take a portfolio approach to investing and look at portfolio risk rather then the risks of individual securities. All three correspond in order to the three financial crisis es mentioned above. However, the prevention of any future crisis depends more on the ethicality of the investment profession then on the tools for risk return analysis for at many instances, the underlying cause of the financial crisis that we have witnessed has been naked greed.