Category: Events

Tackling the challenges of governments as financial institutions

From the MIT Sloan Newsroom:

Governments not only regulate the private financial marketplace, they also own and operate some of the world’s largest financial institutions. Government agencies make trillions of dollars of loans, insure large and complex risks, and design new financial products. Yet their leaders often lack the analytical support and rigorous financial training of their peers in the private sector, and transparency is often lacking.

 

The MIT Center for Finance and Policy officially launched this month to address those gaps, along with other challenges facing financial policy makers.

“This is a big unmet need,” said Professor Deborah Lucas, director of the center. “To have an academic center devoted to the broad swath of government financial policies that have such an enormous effect on the allocation of capital and risk in the world economy.”

“What we want to do is to promote research that policymakers, practitioners, and informed citizens can turn to as an objective source of information when they’re thinking about these policy issues. That information often isn’t available now,” she said.

Research endeavors so far include, among others: the production of a world atlas of government financial institutions, an effort helmed by Lucas to catalog, compare, and evaluate governments’ financial involvement worldwide; a project led by Professor Andrew Lo to develop a dashboard that measures systemic financial risk; a study of the effects of algorithmic and high frequency trading, led by Professor Andrei Kirilenko; and a study of policies on retirement finance led by MIT Sloan professor and Nobel laureate Robert Merton.

Lo, Kirilenko, and Merton are all co-directors of the center.

Along with the research work, Lucas said there is also an educational mission for the center. In many cases, the center’s leaders say, financial problems could have been avoided, mitigated, or at least predicted had public sector workers had an education on par with that received by many private sector finance professionals.

“The idea is to provide the people who are working on finance within a government context with the same skillset as their peers in private industry,” Lucas said. “One reason you see a lack of finance education is because it’s tended to be a rather expensive education. And people going into the public sector may not even realize that finance is what they will need to know.”

At MIT Sloan, work at the center has already led to the creation of Kirilenko’s new course—Core Values, Regulation, and Compliance—as well as a student club on financial markets and policy.

The center began sponsoring events in October 2013, but officially launched Sept. 12-13 with the inaugural MIT Center for Finance and Policy Conference in Cambridge, Mass. More than 120 people attended the invite-only event, which featured discussions on the cost of government credit support, the costs of single-family mortgage insurance, and contagion in financial markets. Peter Fisher, senior director at BlackRock Investment Institute and a former undersecretary at the U.S. Department of the Treasury, gave a keynote talk.

The conference also included a panel discussion on improving government financial institutions, which addressed the need for government agencies to improve how they manage credit portfolios and monitor program risk levels over time. Panel members also discussed ways to raise red flags when there are problems in government credit programs.

The outlook was not entirely dire. “The move toward embracing risk management concepts across the federal government has been impressive in recent years,” said Doug Criscitello, a managing director at Chicago-based audit, tax, and advisory firm Grant Thornton and the former CFO of the U.S. Department of Housing and Urban Development. “We’ve seen the rise of independent risk management offices … that are housed outside the credit extension department.”

Lucas said she believes MIT’s depth in finance, economics, policy, and systems thinking make it the ideal place to study governments as the world’s largest and most complex financial institutions.

“I think an important reason that more academics haven’t taken on these issues—despite their importance—is that they are extremely complex,” she said. “Making progress takes a big investment in understanding institutions and laws and motivations. The problems are inherently interdisciplinary. And MIT is this great institution in terms of having the horsepower and energy to go after it and say ‘We can hit this question from a lot of different dimensions.’”

Professor Robert C. Merton featured speaker at Global Leader Series Economic Forum

Professor Robert C. Merton

Organized by the CUHK Business School, The Global Leader Series Economic Forum held on 16 October “proved a great success, filling the Grand Ballroom of Kowloon Shangri-La with over 600 participants and drawing an impressive array of eminent speakers and attendees. Titled ‘The Rise of the Asian Century’, the forum featured four world-renowned economists: Prof. Liu Mingkang, former Chairman of the China Banking Regulatory Commission; Prof. Robert C. Merton, 1997 Nobel Laureate in Economic Sciences and School of Management Distinguished Professor of Finance at MIT Sloan School of Management; Prof. Lawrence J. Lau, Chairman of CIC International (Hong Kong) Co., Limited; and Prof. Fred Hu, Chairman of Primavera Capital Group. Before a captivated audience, they knowledgeably presented their views on the challenges and opportunities of Asia’s economic and financial development as China continues to gain prominence.”

Click here to see the video footage from this event.

Celebrating Black-Scholes-Merton

Two Nobel Prize winners look back, and forward, as they reflect on their famous model

Professor Robert Merton, in the classroom, 1980

“There are very few academic papers that you have a 40th anniversary for,” said MIT Sloan finance professor Stewart Myers. And yet, in honor of the anniversary of the Black-Scholes-Merton options pricing model, MIT Sloan did just that, with a two-day symposium celebrating the famous model and its widespread adoption and influence.

Capping off a day of talks featuring finance professors including Deborah Lucas and Stephen Ross as well as alumna Judy Lewent, SM ’72, was a fireside chat between Robert Merton and Myron Scholes, moderated by Myers. The group spoke to MIT Sloan students, alumni, and fellow faculty in a packed house that included the daughter of the late economist Fischer Black, as well as at least one former master’s student of Merton’s.

Merton and Scholes won the Nobel Memorial Prize in Economic Sciences for their work on the model, which provides a way to value options and dynamically hedge risk. The model, which can be applied to financial products ranging from interest rate swaps to mortgages as well as to a wide array of corporate investment decisions or “real options,” is notable not only for its ability to solve a challenging problem, but also for its rapid uptake by practitioners and its many uses.

“It isn’t just that they had a formula for a particular thing, it’s that the methodology can be applied so broadly. The range of things it can be applied to is amazing,” said Myers recently.

“The Black-Scholes-Merton option pricing model is probably one of the most successful theories in all of the social sciences,” said finance professor Andrew Lo in an interview before the anniversary event. “It is an idea that has come out of academic research that has been adopted in practice. The approach they created, not just the formula but the theoretical framework they created, launched a thousand additional research papers as well as a lot of industry practices that rely on that framework.”

Entire industries, including the exchange-traded options market, the over-the-counter derivatives market, and the market for credit derivatives, evolved based on Black-Scholes-Merton. “There are multiple trillions of dollars in each of those industries, and at the heart of each of them is the analysis pioneered by Black, Scholes, and Merton,” said Lo, who added that he “uses their ideas all the time” in his own work on quantitative models in financial economics.

Lessons learned

At the event, Merton and Scholes shared good-natured ribbing and humorous anecdotes about the model’s evolution, including a story Scholes told about giving an early public presentation of the work together with Black and waiting for Merton to reveal the grand finale—only to find that Merton, who did not appear, had overslept.

The pair agreed that they could not have imagined the model’s impact when they published their work in 1973. Indeed, the now famous paper was initially rejected by multiple academic journals whose editors deemed it “too arcane.” It was only when friends at the University of Chicago—Eugene Fama and Merton Miller—pressed their contacts at the Journal of Political Economy that the model finally made it into print.

When discussing the model’s use in practice and their own early trading experience applying it, Merton and Scholes advised the audience that even the most sophisticated model is no match for a trader with inside information. “The market knows things that the models don’t,” said Merton. “One ounce of non-public information is going to clean the clock of the smartest person with the model and no information. You have to ask yourself, ‘Is there somebody who knows more?’ Use the model, use history, but also use what the market is telling you.”

Looking ahead to the next 40 years, Scholes said corporate managers could use the model as they decide how to structure their companies in an increasingly technologically advanced world. The Black-Scholes-Merton approach could help determine whether or where to manufacture goods, for example, or which products to develop or innovations to pursue and which to abandon.

Merton added that the model could also be applied to risk management in emerging markets and that it could help central bankers better understand their risks as they strive to avoid another financial crisis. Developing financial markets like China’s could also rely on the model to build a stronger, safer financial system that appropriately transfers risk.

“I think it will be expanded and extended in many different ways,” said Lo. “One hundred years from now, people will still be reading about Black-Scholes-Merton.”

Videos from the events can be found at the MIT Sloan Finance TechTV site here: http://techtv.mit.edu/collections/mitsloanfinance/videos