UnRisk 7

Buffett and Derivatives: Enthusiasm, Anger, Disbelief, Acceptance

Denial, anger, bargaining, depression, acceptance, according to Elizabeth K├╝bler-Ross the five stages of dealing with personal tragedy. I wonder if there's something similar we are going through with financial derivatives? If so, I think Warren Buffett is at the anger stage. "If you need to use a computer or a calculator to make the calculation, you shouldn't buy it," is his view on investing, famously calling derivatives "Weapons of mass destruction" a few years ago. I sympathize, and I speak as one of the mathematicians who works with derivatives for a living.

In my experience there are just four stages of dealing with derivatives, and they are: naive enthusiasm, as one experiences the glorious possibilities of derivatives in one's portfolio, then righteous anger as one suffers horrendous losses, followed by confused disbelief, as one realises that no one fully understood the risk in these dastardly creations, least of all the bankers, and finally a reluctant acceptance as one admits that these things are here to stay. Let's go through these stages one by one, while I explain what each means in terms of risk.

Naive enthusiasm: Derivatives are wonderful financial contracts, they allow you to finely tune your investment portfolio to benefit from your market views, assuming they turn out to be correct. My bank manager has recently been trying to sell me a contract that will give me over 5% return in one year if gold stays within a certain trading range. In market parlance this is called a double knockout quanto option. Or derivatives can be used to hedge risk from other business activities. If you regularly sell widgets to Japan you are exposed to dollar/yen exchange-rate risk. A derivative can be designed to reduce that risk for you. So far so good.

Righteous anger: Who wouldn't be angry after the trillions of dollars that have been lost thanks to CDOs, MBSs, and all the other acronyms? The problem though is not the derivatives themselves, rather the way that the derivatives have swamped the market for simple stocks and shares. The notional outstanding of all derivatives globally is over a quadrillion dollars. What, you thought trillions was bad enough? You, ain't seen nothing yet!

So rather than derivatives existing to help you manage risk, or profit from precise market views, the market has grown so much that derivatives seem to be there just to allow crazy leverage, risk taking on levels never seen before. And at this point the risk-management quants step in to say, don't worry we've got our fancy mathematical models that show there is actually no risk.

Buffett's right-hand man, Charlie Munger, has said about higher mathematics in finance "They teach that in business schools because, well, they've got to do something." Now that really hits the nail on the head. When your competitor university across the river is charging 50, 60, 70 thousand dollars for a one-year Masters course in Financial Engineering, what are you going to do? Are you going to say you don't have any faculty that understand derivatives? Hell, no. You are going to get your smartest mathematicians together and make up a syllabus. Are your 23-year old victims, sorry I mean students, going to know any better? In 2000 I warned about the dangers of a "mathematician-led market meltdown" after seeing what had happened at LTCM and how identikit risk managers were being churned out from Masters programs, and how Groupthink was beginning to dominate risk research and derivatives valuation. I sympathize totally with Warren Buffett and Charlie Munger.

Confused disbelief: I'm a great believer in education playing a bigger role in derivatives in future. But not the sort of education that we've got at the moment. I understand Warren Buffett when he says "The more symbols they could work into their writing the more they were revered." Universities are churning out many thousands of 'experts' in the analysis of derivatives but sadly they know more about the math and the symbols than they do about the markets. But again it's not the symbols themselves that are to blame, for we happily fly on airplanes designed using similar symbols, rather it's the lack of financial empathy exhibited by the multiple-PhD'd analysts, the quants, that worries me. Remember this is a mathematician writing this, but one who has been saying less is more for over a decade now.

Reluctant acceptance: I've blogged in the past about the "mathematics sweet spot" for finance, where the models are not dumbed down, but equally they are not fantastically over complicated (to impress, as I expect Buffett would say). I don't think we can go back to a dark ages before derivatives and quantitative finance, but I do believe that we desperately need to rethink the type of education that those 23-year olds, soon to be in charge of your pension, are getting. Less math, fewer symbols, more commonsense, and more market know-how.

And in this respect I think I'm a few stages ahead of Mr Buffett.