Abstract
We have witnessed three major stock market meltdowns over the past three decades. This paper assesses the market shocks of 1987, 1997 and 2008. In particular, we review the history of modern finance and assess whether the role of quantitative finance has developed to reduce the likelihood of future meltdowns. We see that the role of models based on historical price movement often ignore the possibility of fat tails, that risk free arbitrage may exist in normal, but not tumultuous markets and that asset returns and correlations result in extreme values more frequently than predicted by the standard bell curve. Moreover, the desire for outsized returns has driven many money managers to leverage their returns beyond prudent levels, dramatically increasing portfolio risk. In addition, many in Wall Street sell and create new derivative products that are often sold without the necessary due diligence and properly conducted stress tests. The same quantitative courses are taught and similar derivative products are sold as during the three previous meltdowns. Unfortunately, the SEC and academia have taken little permanent action to reduce the odds of further stock meltdowns.
Highlights
It’s been seven years since the last financial meltdown
While there were many parties culpable in this dramatic downturn, including bankers, credit rating agencies, mortgage brokers, hedge funds and others, without the blind acceptance of the quant models it is doubtful whether the worst stock market disaster since the great depression would have occurred
After the third market collapse in 20 years driven by the quants, quantitative finance is still valued by business schools throughout the country
Summary
It’s been seven years since the last financial meltdown. Let’s consider the situations that generated the meltdowns of the past 30 years and ask whether markets have changed. During past twenty years, the mathematics of finance has become so complex and integral to the understanding of financial products that few who buy, sell or create the products of Wall Street understand the ramifications of the assumptions imbedded in the products being sold. An analysis of the role of the quants in the recent history of financial innovation and market meltdowns is illuminating. A review of the role of derivatives in the meltdowns since 1987 is useful to understand
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