1. Don Mango American Re-Insurance Don Mango American Re-Insurance Unsolved Problems in Financial Science

2. OutlineOutline What is Financial Science? Data Capital Treatment Content-less volatility Market-sensitive risk measures Value versus Price Convergence in Modeling Adaptive Systems What is Financial Science? Data Capital Treatment Content-less volatility Market-sensitive risk measures Value versus Price Convergence in Modeling Adaptive Systems

3. What is Financial Science? Converging field with roots in finance, financial economics, economics, financial engineering, insurance, and actuarial science. Study of contingent financial activities (loans, insurance policies, bonds, derivatives, stocks), and their structure, valuation, sale, exchange, accumulation, and interaction. Converging field with roots in finance, financial economics, economics, financial engineering, insurance, and actuarial science. Study of contingent financial activities (loans, insurance policies, bonds, derivatives, stocks), and their structure, valuation, sale, exchange, accumulation, and interaction.

4. DataData Sequence for a “regular” science (e.g., Chemistry): Hypothesis and predictions Experimental design Experiment Data collection Data analysis Conclusions and refinements Bottom line: lot of thought and effort before a single number shows up Sequence for a “regular” science (e.g., Chemistry): Hypothesis and predictions Experimental design Experiment Data collection Data analysis Conclusions and refinements Bottom line: lot of thought and effort before a single number shows up

5. DataData Sequence for financial science: Data collection Data analysis Hypothesis and predictions? Conclusions and refinements? We got numbers, oh do we got numbers Experiments are “emergent” Sequence for financial science: Data collection Data analysis Hypothesis and predictions? Conclusions and refinements? We got numbers, oh do we got numbers Experiments are “emergent”

6. DataData Experimental design – forget it Experiment = the market itself! F.A. Hayek, “Competition as a Discovery Procedure” Competition is a parallel process of experimentation and hypothesis testing Experimental design – forget it Experiment = the market itself! F.A. Hayek, “Competition as a Discovery Procedure” Competition is a parallel process of experimentation and hypothesis testing

7. Content-less Volatility J. Doyne Farmer (Santa Fe Institute) and Shareen Joshi, “The Price Dynamics of Common Trading Strategies” Interaction of agents’ strategies induces volatility Can be mutually reinforcing (negative feedback) The volatility is symptomatic of our own actions, not fundamental to the assets. Can happen “without innovations” J. Doyne Farmer (Santa Fe Institute) and Shareen Joshi, “The Price Dynamics of Common Trading Strategies” Interaction of agents’ strategies induces volatility Can be mutually reinforcing (negative feedback) The volatility is symptomatic of our own actions, not fundamental to the assets. Can happen “without innovations”

8. Market-Sensitive Risk Measures Avinash Persaud, State Street Bank  “Sending the Herd Off the Cliff Edge: The Disturbing Interaction Between Herding and Market-Sensitive Risk Management Practices” Institute of International Finance 2000 Essay Contest Winner One of the most important works in recent literature Available free at www.erisk.com/reference/archive/persaud.pdf Avinash Persaud, State Street Bank  “Sending the Herd Off the Cliff Edge: The Disturbing Interaction Between Herding and Market-Sensitive Risk Management Practices” Institute of International Finance 2000 Essay Contest Winner One of the most important works in recent literature Available free at www.erisk.com/reference/archive/persaud.pdf

9. Market-Sensitive Risk Measures In short run: Markets find it hard to distinguish between good and unsustainable Market participants herd Contagion is common In a herding environment: Tighter market-sensitive risk management systems and more transparency makes markets less stable and more prone to crisis Volatility contagion across unforeseen dimensions In short run: Markets find it hard to distinguish between good and unsustainable Market participants herd Contagion is common In a herding environment: Tighter market-sensitive risk management systems and more transparency makes markets less stable and more prone to crisis Volatility contagion across unforeseen dimensions

10. Value versus Price Imprecise communication uses them interchangeably Value requires Interpretation, Filters Preferences, Judgment Expectations, Trends Models Context of your situation, existing portfolio, strategy Imprecise communication uses them interchangeably Value requires Interpretation, Filters Preferences, Judgment Expectations, Trends Models Context of your situation, existing portfolio, strategy

11. Value versus Price Market Price = A record of a transaction… …which is an agreement of acceptable value in exchange… …between two parties who e-VALUE-ate the transaction The presence of the market means that some of that evaluation process takes into consideration the possible future price Market Price = A record of a transaction… …which is an agreement of acceptable value in exchange… …between two parties who e-VALUE-ate the transaction The presence of the market means that some of that evaluation process takes into consideration the possible future price

12. Convergence in Modeling No more normal distributions Not just measure change or value transform Dr. Novosyolov’s paper An analytic framework that can express varying opinions Let’s develop a common structure, then we can argue over parameters! No more normal distributions Not just measure change or value transform Dr. Novosyolov’s paper An analytic framework that can express varying opinions Let’s develop a common structure, then we can argue over parameters!

13. Adaptive Systems Previous paradigm: Rational representative agent Equilibrium Analytically tractable model New concepts: Bounded rationality Heterogeneous agents Computational solution Evolution Previous paradigm: Rational representative agent Equilibrium Analytically tractable model New concepts: Bounded rationality Heterogeneous agents Computational solution Evolution

14. Adaptive Systems Huge research community in adaptive modeling: Financial markets Water policy Social sciences Military See National Academy of Sciences 2001 Sackler Symposium “Adaptive Agents, Intelligence, and Emergent Human Organization: Capturing Complexity through Agent-Based Modeling” Huge research community in adaptive modeling: Financial markets Water policy Social sciences Military See National Academy of Sciences 2001 Sackler Symposium “Adaptive Agents, Intelligence, and Emergent Human Organization: Capturing Complexity through Agent-Based Modeling”

15. Adaptive Systems Movement from analytic to computational solutions A valid third alternative “symbol system” (verbal, mathematical, computational) Homogeneous representative agents to heterogeneous agents interacting Changes the concept of a “solution” Movement from analytic to computational solutions A valid third alternative “symbol system” (verbal, mathematical, computational) Homogeneous representative agents to heterogeneous agents interacting Changes the concept of a “solution”

16. Adaptive Systems This gives us the ability to address: Interaction effects Policy changes Strategic interference patterns It forces us to work together! It changes the nature of the resulting work product Almost a new medium This gives us the ability to address: Interaction effects Policy changes Strategic interference patterns It forces us to work together! It changes the nature of the resulting work product Almost a new medium

17. Adaptive Systems Examples Trojan Mice Great introduction to the concepts www.trojanmice.com Trojan Mice Great introduction to the concepts www.trojanmice.com

18. Adaptive Systems Examples NuTech Solutions Southwest Airlines cargo handling procedures NASDAQ impact of decimalization See the Case Studies portion of their website www.nutechsolutions.com NuTech Solutions Southwest Airlines cargo handling procedures NASDAQ impact of decimalization See the Case Studies portion of their website www.nutechsolutions.com