The renaissance of financial engineering in recent years has been every bit as striking as the returns once promised by some of the discipline’s boldest proponents.
Not too long ago, it seemed like the game was over for the field of study that produced mortgage-backed securities, credit default swaps and all sorts of other exotic derivatives that exploded from so dramatically during the financial crisis of 2008.
Today, financial engineering theory is being touted by several academics as the key to curing cancer faster, reducing the impact of climate change, and imposing better risk discipline on the same banks that were once nearly brought down. by the creations of the discipline.
Graduates are flocking to specialty courses in record numbers, with Columbia receiving more than 1,200 applications for a course that has fewer than 90 seats, and Cornell attracting more than 1,000 applications for a course with only 55 seats.
“It was Warren Buffett who said that derivatives are weapons of mass destruction of financial markets,” says Andrew Lo, MIT Sloan professor of finance and hedge fund manager behind pioneering work on how financial theory can help cure cancer.
“The uncontrolled use of these types of weapons could be extremely devastating and create nuclear fallout for decades. . . If we use these powerful tools in a responsible and controlled manner, the power they can deliver is virtually limitless.”
Mr. Lo has spent years studying how the principles of financial theory can be applied to the fight against cancer. “In cancer drug development, because the chances of failure are so high, the likelihood of success increases dramatically if you build a portfolio,” says Lo.
He adds that the historical probability of success for the development of a single cancer treatment is about 5%. But the probability of success climbs to 99.59% in a portfolio of 150 anticancer drugs whose successes are not statistically correlated. That 99.59% isn’t just the chance that one drug will be successful, it’s the chance that two or more will end up being approved by the US Food and Drug Administration.
UBS Oncology Fund Size
With financial rewards for each success potentially fetching billions of dollars, Lo believes it is safer to invest in cancer drugs on a large enough scale than to focus on a long-term goal. Lo bases his research on the binomial distribution — a theory of probability that examines the distribution of the results of a repeated test — and basic portfolio theory, which advocates the benefits of holding a group of complementary assets. Lo cites UBS’s recently launched $470 million oncology fund as a concrete example of portfolio theory.
Another example of widely used financial engineering is Bob Litterman’s work on climate change. Mr Litterman, a former risk manager at Goldman Sachs who now works at hedge fund Kepos Capital, has studied how asset pricing theory can be applied to the true price of carbon.
He concluded that carbon is massively undervalued and that we are on course for a sharp and painful correction. He thinks more work between climate scientists and financial modellers is needed to understand how carbon should be priced.
“They [economists] did not take the science very seriously in projecting damage and especially in projecting the full possible distribution of damage [from climate change]says Litterman. “Ultimately, these economic models can give us the social cost of carbon from $2 a ton to several hundred dollars a ton,” he adds, quoting a Report of the Intergovernmental Panel on Climate Change.
Some investors are already positioning themselves for the correction, including the World Wildlife Fund, of which Mr. Litterman is a director. The fund bought a derivative that swaps the total return of an index of carbon-intensive assets like coal, tar and expensive oil sources for the total return of an index of the S&P 500. The value of the swap rose 73 percent. cent since its inception by WWF advisers, Cambridge Associates, in 2014.
Peter Carr, chair of New York University’s Tandon Department of Finance and Risk, says financial engineering can be applied to anything systemic or pervasive. He cites examples of weather forecasting and human responses to drugs. His students use financial engineering to study the systemic risk of banks. “Financial engineers are already well trained to understand what values will be in the future,” he says. “It’s valuable for banks that need staff to cope with additional demands [from regulators].”
Victoria Averbukh, director and senior lecturer in the financial engineering department at Cornell in Manhattan, says more of her students are planning to work in risk management.
“The financial industry comes back for financial engineers where they have to solve their risk management problems and they have to analyze the data,” she says. “There was a backlash against engineering. . . Now it’s moving forward. »