Monday, November 16, 2009

Is Financial Markets' Behaviour Beyond Our Comprehension?

Uncertainty is neither good for business nor for markets. Physicist, Statisticians, Mathematicians try to measure the uncertainties and quantify it. More one can measure and predict outcomes in a market, more the market grows. Having modelled as 'Efficient Markets', the financial markets grew by leaps and bounds and left behind the real economy in recent decade. However, the present financial crisis has again put the question mark on our understanding of market behaviour. The risk assessment methodologies behind MBS credit ratings failed. The bell curve of risk distribution developed fatter tails during crisis. 'Efficient market' theory has crumbled under the weight of these failures.

Efforts are on to develop better theories which will incorporate not only market mechanics but also market participants. The big question is that how does one model the irrationality of market participants?

  • Considering markets as 'Turbulent' systems allows one to apply physics of wind and turbulence.
  • Considering markets as complex and evolving ecosystems, one can apply Charles Darwin theories.
  • And third possibility is to study it on behavioural lines which use human psychology studies to explain the irrational behaviour of individuals and markets.

Regardless of the theory and approach taken, the market participants seek mathematical rigor and precision which can measure all the uncertainties for them and aid in decision making.

However, 'Is it really possible to capture the human irrationality and market mechanics.. all together in statistical and mathematical models?'. Can we replace the human judgement? This is precisely the point of debate between 'Principle based regulation' and 'Rule based regulation' of financial sector. Principle based regulation allows a level of discretion to regulatory authorities where they can apply their judgement and intervene only when required. Rule based regulation with elaborate rules (based on 'Efficient Market' theory) turned out to be inadequate to prevent the market participants from taking irrational decisions and the crisis ensued. One cannot blame the researchers behind the credit risk model of CDOs for the failure. They had clearly communicated the limitations of the model, but the bankers chose to ignore them. '...As long as the music is playing, you've to get up and dance...' Charles Prince, CEO, Citigroup.

As we wait for the mathematicians, statisticians, physicist, psychologist, anthropologist and others to work out the mathematical model to describe market behaviour, which would be more complex than ever, till then....... Lets embrace 'Prudence' along with conventional knowledge.

Both Precision and Prudence will have to go together if we wish to understand markets and avoid such crisis in future.

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