Financial Academia and the Street – A Comprehensive Disconnect

1994 AD.

My friends in the Physics Department of the University of Konstanz, Germany, were busy trying to increase the number of holes on a silicon strip.

This was nanotech research in its advanced stage.

Nanotech saw successful implementation in the real world, though the explosion is yet to come. Nevertheless, the key words here are successful implementation.

Successful implementation on the street is only possible when a research model is practical.

Financial academia time and again delivers impractical models and is then surprised when they meet with failure on the street.

Let’s take the case of the Long Term Capital Management hedge fund. Nobel laureates ran it. They did not incorporate the possibility of a sovereign debt default in their model. So sure were they of themselves, that they went on to buy billions of dollars worth of derivatives, leveraging themselves to the hilt. Their total leverage in the end stood at 250:1. The sovereign debt default by the Russian government in 1998 triggered the LTCM fund to go belly up, and with it disappeared the life-savings of thousands of trusting investors. The ripple effects of this disaster almost knocked the world’s financial system off its platform. Talk about disconnect.

Currently, we are seeing the effects of another disconnect in action.

The Euro was conceived on the basis of hundreds of PhD theses and tons of post-doctoral research. What the researchers couldn’t possibly incorporate in their models were some basic human and emotional facts.

For starters, let’s try the Greeks. They like to retire early and work lesser than their Eurozone colleagues. Their bankers are gullible and not too street-smart, and have made some really bad bets.

Italians like to take short-cuts. They like to over-price and under-cut.

Germans like to go the whole hog. They are punctual and more environment-conscious. They do not like subsidizing those who don’t work for it.

French farmers want to sell their milk for its proper price. They and the majority of their nation dislikes subsidizing others who might not deserve subsidy.

One could go on. The list is endless.

How does one incorporate such realistic “human” stuff in mathematical models?

One can’t.

Mathematics doesn’t possess the language to reflect such human and emotional factors.

So what do these theses contain, upon which the Euro has been built. Other, disconnected stuff, no realistic, street-related emotional / human factors of value.

What we’re seeing is real disconnect in action. Financial academia is way out of its depth on the European street or for that matter on any other street. It should lay off from the street so that further disasters are prevented.

Let’s hope and pray that the Euro-chapter does not meet with a harmful end.

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