Finance

The underlying paper examines three financial disasters and critically discusses the roles of modern portfolio theory and financial engineering in those disasters. The paper describes modern portfolio theory as a computer program which optimizes the risk and return combinations for an investor. MPT provides two outputs for an investor, namely, efficient frontier (or, the risk-return trade-off) and the portfolio that produces the optimal risk-return combination. MPT requires three inputs to provide these outputs these are expected returns for each security, co-variance estimates, and constraints on the choice of portfolio. In these inputs the co-variance estimate has significance, as it affects the correlation between the securities and higher the negative correlation between the securities, lesser the combined risk of the portfolio would be achieved.
Further, the paper describes financial engineering as a process which involves investment vehicles like options etc. Values of options are derived from underlying securities using Black-Scholes-Merton option pricing model. BSM model uses stock price, exercise price, interest rate and expiration date of the option to calculate the option price.

Next, the paper traces the causes of recent financial disasters to these two theories. The first disaster explained is Black Monday, known for the global market crash on 19 October 1987. The cause of the crash lies on the way option pricing theory is used to calculate the price of an option. The BSM analysis implies that, in the frictionless world a call is redundant because they can be replicated by shifting between cash and the stock as the stock price moves up and down. This replication of a call option is termed as synthetic call. To replicate the outcome of call, the synthetic call must increase its position in the security as the price goes up and decrease its position in the security as the price falls. However, the problem in this analysis lies in its unrealistic assumptions that markets are continuous in time and infinitely liquid.

The problem started when portfolio insurers (participants capturing the upside of the market by replicating the call options by taking long positions in future) started selling the index futures, after the substantial fall in the market on the Wednesday through Friday of the previous week. This higher selling pressure on the future contracts caused disequilibrium in the relationship between the future price and the spot price, which was not even controlled by the index arbitrageurs.

The next disaster explained is Long Term Capital Management (LTCM), which was a large, highly leveraged hedge fund. LTCM used MPT rather than BSM to judge the safety of its portfolios. LTCM used to go short the liquid side (30 years treasury bills) of many markets and long the illiquid side (29 years treasury bills). On 1998 after the Russian default there was great demand for liquidity and corresponding flight from illiquid assets, which resulted in its accounts being wiped out after marking it to market. The major problem in LTCM is considered to be its high leverage, which magnified the brunt of the Russian default.

At the last the recent financial crisis highlights the importance of correlation risks. The major cause of this crisis is the structure of various products which were created using complex financial engineering such as, Collateralized Mortgage Obligations pooled together high leveraged mortgages and then these CMOs adding their own leverage to the mixture and further complexing the structure. The other cause was the financing of the mortgages for low cost housing and mandating the subprime loans.

Finally, the paper proposes three best practice MPT to prevent investors from the exposures that represent the points at which models are most apt to breakdown.  The first suggestion proposed is not to take positions in derivatives of complex nature unless investors understand its nature and the related risks. Had this practice been followed, the recent financial crisis would not have been as severe as it turned to be, because most of the investors who invested in CDOs and CMOs were not at all aware of the associated risks and their exact natures. The second best practice proposed is, during the times of market panic, one with high leverage is wiped out. So, investments should not be highly leveraged as it was in the case of LTCM. Finally, the investors should think about the portfolio as a whole and should remember the law of average covariance. For example, a portfolio of Credit Default Swaps is in fact a portfolio of insurance policies guaranteeing correlated risks.