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Sunday, April 12, 2009

Merton on the financial crisis

This talk is long but very good. If you are impatient you can skip to the last 3 minutes where Merton answers a question about the CDS market that has been widely discussed. He points out the value for real world companies of being able to transfer credit risk as opposed to the narrower application of insuring a bond that they actually own.

The central point of the first part of the talk -- the embedded put option in a plain vanilla loan, and associated nonlinearities -- is nice but I don't think it is as essential to the current crisis as he suggests. (It's obviously in his interests to downplay the complexity of new financial instruments relative to traditional ones. The difference, of course, is that we've had much more time to get used to the traditional ones and build the proper safeguards and regulatory systems.) Merton is refreshingly modest about his understanding of the complex causes of the crisis. At one point he notes that the post mortem investigation into the crisis is unlikely to produce a Feynman moment, in which someone holds up an O-ring that caused the disaster!

Here is another link in case the player below doesn't work for you.

I sat in on Merton's graduate class on options pricing theory at Harvard in the early 1990s. I still have the lecture notes and a black paperback copy of Continuous Time Finance. He seemed much more confident at the time, but of course that was before LTCM :-)

I was one of the first people to recast options pricing theory into the language of Feynman path integrals. (You don't need the power of quantum field theory for this; the log of the price of the underlying security is just the position of a particle in simple 1D quantum mechanics in imaginary time -- i.e., it's just Brownian motion.) A friend of mine had been assigned a thesis project by Andy Lo at MIT, to price a certain type of exotic, path dependent option sold by Citibank. Lo didn't know the option could be priced in closed form (neither did Citi, it turns out); he asked my friend to do it numerically by brute force Monte Carlo. Using path integrals I found an exact expression for my friend, which agreed perfectly with his simulations.

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