The importance of understanding assumptions in financial innovation

2019 Investment Innovation Conference Coverage

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weatherall-jamesBy looking at what went wrong with financial innovations of the past, investors can learn how to protect themselves and look for opportunities going forward, said James Weatherall, professor of logic and the philosophy of science at the University of California, Irvine, speaking at Canadian Investment Review‘s 2019 Investment Innovation Conference in November.

As an example, he pointed to portfolio insurance and how it performed during the Black Monday Crash of 1987.

A key development that enabled portfolio insurance to become a reality was the Black-Scholes model, which is a well-known model for pricing options contracts that also provided a recipe for constructing options. By the late 1970s, the Black-Scholes model was widespread, as were derivatives and options trading, Weatherall noted.

And then, in 1976, portfolio insurance came onto the scene. “And the basic claim was, ‘Look, you don’t want to lose everything in a market downturn. One way of protecting yourself is to buy a put option on the whole market.’”

To do this, investors didn’t need to actually buy a put option on the whole market because they could construct an option out of a portfolio of other assets, which are much more readily available.

In essence, portfolio insurance allowed for the manufacturing of a put option that was claimed to offer protection in market downturns, Weatherall noted.

Then came the Black Monday crash of October 19, 1987. And portfolio insurance failed.

“In fact, portfolio insurance arguably contributed to the size of the downturn, for a number of different reasons,” Weatherall said. “Partly because people were taking riskier positions because they thought they were protected, partially because [of] what was involved in actually unwinding the positions that were theoretically supposed to be equivalent to put options.”

After this failure, Fischer Black wrote a paper outlining how people using the model had missed the point and highlighting all the assumptions at the model’s core. “And what he did, was he went on to elaborate in detail, in a way that really hadn’t been done before, the specific assumptions that had gone into the Black-Scholes model,” Weatherall said.

It’s important to recognize that conclusions drawn from a model are only as good as the assumptions that went into it, Weatherall said. And models can actually change how markets work.” Innovations can change how markets work because they change the way that people think about the activities that they’re engaged in.”

For example, if people are inclined to think of portfolio insurance as an insurance policy, this is different than thinking about it as an option or an investment strategy. “When the innovation actually involves a whole bunch of mathematical work based on assumptions that are only going to be good under some circumstances, the whole thing becomes a lot more risky-looking. You’re inclined to think of it not as an insurance policy in the traditional sense, but as a kind of investment strategy that you have to be cautious about and you have to look at very carefully.”

Yet, once investors recognize how innovations can change markets, they can also find ways to protect themselves and find opportunities, Weatherall said.

“I think the important takeaway here is be vigilant,” he added. “Be vigilant for not just mathematical models, but also more causal mental models, like ways of speaking, that get built into financial practices, financial innovation, in such a way that the people who are engaging most with these practices may not be aware of the assumptions that they’re making.”

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