The Origin of Bounded Rationality and Intelligence2013
Rational economic behavior in which individuals maximize their own self-interest is only one of many possible types of behavior that arise from natural selection. Given an initial population of individuals, each assigned a purely arbitrary behavior with respect to a binary choice problem, and assuming that offspring behave identically to their parents, only those behaviors linked to reproductive success will survive, and less successful behaviors will disappear exponentially fast. This framework yields a single evolutionary explanation for the origin of several behaviors that have been observed in organisms ranging from bacteria to humans, including risk-sensitive foraging, risk aversion, loss aversion, probability matching, randomization, and diversification. The key to understanding which types of behavior are more likely to survive is how behavior affects reproductive success in a given population's environment. From this perspective, intelligence is naturally defined as behavior that increases the likelihood of reproductive success, and bounds on rationality are determined by physiological and environmental constraints.
On a New Approach for Analyzing and Managing Macrofinancial Risks2013
At the fifth annual CFA Institute European Investment Conference on 19 October 2012 in Prague, Robert C. Merton gave a presentation on analyzing and managing macrofinancial risk. This article is based on his talk and on research he carried out with his coauthors.
Can Financial Engineering Cure Cancer?2013
Traditional financing sources such as private and public equity may not be ideal for investment projects with low probabilities of success, long time horizons, and large capital requirements. Nevertheless, such projects, if not too highly correlated, may yield attractive risk-adjusted returns when combined into a single portfolio. Such "megafund" portfolios may be too large to finance through private or public equity alone. But with sufficient diversification and risk analytics, debt financing via securitization may be feasible. Credit enhancements (i.e., derivatives and government guarantees) can also improve megafund economics. We present an analytical framework and illustrative empirical examples involving cancer research. Open-source software available in the link above.
Using Algorithmic Attribution Techniques To Determine Authorship In Unsigned Judicial Opinions2013
This article proposes a novel and provocative analysis of judicial opinions that are published without indicating individual authorship. Our approach provides an unbiased, quantitative, and computer scientific answer to a problem that has long plagued legal commentators. Our work uses natural language processing to predict authorship of judicial opinions that are unsigned or whose attribution is disputed. Using a dataset of Supreme Court opinions with known authorship, we identify key words and phrases that can, to a high degree of accuracy, predict authorship. Thus, our method makes accessible an important class of cases heretofore inaccessible. For illustrative purposes, we explain our process as applied to the Obamacare decision, in which the authorship of a joint dissent was subject to significant popular speculation. We conclude with a chart predicting the author of every unsigned per curiam opinion during the Roberts Court.
Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents2013
Financial markets have undergone a remarkable transformation over the past two decades due to advances in technology. These advances include faster and cheaper computers, greater connectivity among market participants, and perhaps most important of all, more sophisticated trading algorithms. The benefits of such financial technology are evident: lower transactions costs, faster executions, and greater volume of trades. However, like any technology, trading technology has unintended consequences. In this paper, we review key innovations in trading technology starting with portfolio optimization in the 1950s and ending with high-frequency trading in the late 2000s, as well as opportunities, challenges, and economic incentives that accompanied these developments. We also discuss potential threats to financial stability created or facilitated by algorithmic trading and propose “Financial Regulation 2.0,” a set of design principles for bringing the current financial regulatory framework into the Digital Age.
Systemic Risk and the Refinancing Ratchet Effect2013
The combination of rising home prices, declining interest rates, and near-frictionless refinancing opportunities can create unintentional synchronization of home owner leverage, leading to a ‘‘ratchet’’ effect on leverage because homes are indivisible and owner-occupants cannot raise equity to reduce leverage when home prices fall. Our simulation of the U.S. housing market yields potential losses of $1.7 trillion from June 2006 to December 2008 with cash-out refinancing vs. only $330 billion in the absence of cash-out refinancing. The refinancing ratchet effect is a new type of systemic risk in the financial system and does not rely on any dysfunctional behaviors.
What’s the Use of Economics? Teaching the Dismal Science after the Crisis, Chapter 72012
With the financial crisis continuing after five years, people are questioning why economics failed either to send an adequate early warning ahead of the crisis or to resolve it quickly. The gap between important real-world problems and the workhorse mathematical model-based economics being taught to students has become a chasm. Students continue to be taught as if not much has changed since the crisis, as there is no consensus about how to change the curriculum. Meanwhile, employer discontent with the knowledge and skills of their graduate economist recruits has been growing. This book examines what economists need to bring to their jobs, and the way in which education in universities could be improved to fit graduates better for the real world. It is based on an international conference in February 2012, sponsored by the UK Government Economic Service and the Bank of England, which brought employers and academics together. Three themes emerged: the narrow range of skills and knowledge demonstrated by graduates; the need for reform of the content of the courses they are taught; and the barriers to curriculum reform. While some issues remain unresolved, there was strong agreement on such key issues as the strengthening of economic history, the teaching of inductive as well as deductive reasoning, critical evaluation and communication skills, and a better alignment of lecturers' incentives with the needs of their students.
Rethinking the Financial Crisis2012
Some economic events are so major and unsettling that they “change everything.” Such is the case with the financial crisis that started in the summer of 2007 and is still a drag on the world economy. Yet enough time has now elapsed for economists to consider questions that run deeper than the usual focus on the immediate causes and consequences of the crisis. How have these stunning events changed our thinking about the role of the financial system in the economy, about the costs and benefits of financial innovation, about the efficiency of financial markets, and about the role the government should play in regulating finance? In Rethinking the Financial Crisis, some of the nation’s most renowned economists share their assessments of particular aspects of the crisis and reconsider the way we think about the financial system and its role in the economy.
Robust Ranking and Portfolio Optimization2012
The portfolio optimization problem has attracted researchers from many disciplines to resolve the issue of poor out-of-sample performance due to estimation errors in the expected returns. A practical method for portfolio construction is to use assets’ ordering information, expressed in the form of preferences over the stocks, instead of the exact expected returns. Due to the fact that the ranking itself is often described with uncertainty, we introduce a generic robust ranking model and apply it to portfolio optimization. In this problem, there are n objects whose ranking is in a discrete uncertainty set. We want to find a weight vector that maximizes some generic objective function for the worst realization of the ranking. This robust ranking problem is a mixed integer minimax problem and is very difficult to solve in general. To solve this robust ranking problem, we apply the constraint generation method, where constraints are efficiently generated by solving a network flow problem. For empirical tests, we use post-earnings-announcement drifts to obtain ranking uncertainty sets for the stocks in the DJIA index. We demonstrate that our robust portfolios produce smaller risk compared to their non-robust counterparts.
What Post-Crisis Changes Does the Economics Discipline Need?: Beware of Theory Envy!2012
This is a pre-conference essay prepared for 'What Post-Crisis Changes Does the Economics Discipline Need?', a conference organized by Diane Coyle and Enlightenment Economics, the Bank of England, and the U.K. Government Economic Service on 7 February 2012. In this essay, I trace the origins of 'theory envy' to Paul Samuelson and the mathematization of economics over the past half century, and consider its implications for how economics should be taught. Although this research program has produced many genuine breakthroughs in economics, any virtue can become a vice when taken to an extreme, and the recent financial crisis has given us an opportunity to reinvent our field. One innovation is to teach economics not from an axiomatic and technique-oriented perspective, but by posing challenges that can only be addressed through economic logic. Instead of starting microeconomics with the consumer’s problem of maximizing utility subject to a budget constraint, begin by challenging students to predict the impact of a gasoline tax on the price of gasoline, or asking them to explain why diamonds are so much more expensive than water, despite the fact that the latter is critical for survival unlike the former. Instead of starting macroeconomics with national income accounts, begin with the question of how to measure and manage the wealth of nations, or why inflation can be so disruptive to economic growth. Without the proper institutional, political, and historical context in which to interpret economic models, constrained optimization methods and fixed-point existence proofs have much less meaning and are more likely to give rise to theory envy. However, when students understand the “why” of their course of study, even the most complex mathematical tools can be mastered and are almost always applied more meaningfully.
A Survey of Systemic Risk Analytics2012
We provide a survey of 31 quantitative measures of systemic risk in the economics and finance literature, chosen to span key themes and issues in systemic risk measurement and management. We motivate these measures from the supervisory, research, and data perspectives in the main text, and present concise definitions of each risk measure--including required inputs, expected outputs, and data requirements--in an extensive appendix. To encourage experimentation and innovation among as broad an audience as possible, we have developed open-source Matlab code for most of the analytics surveyed, available for download above.
Commercializing Biomedical Research through Securitization Techniques2012
Biomedical innovation has become riskier, more expensive and more difficult to finance with traditional sources such as private and public equity. Here we propose a financial structure in which a large number of biomedical programs at various stages of development are funded by a single entity to substantially reduce the portfolio's risk. The portfolio entity can finance its activities by issuing debt, a critical advantage because a much large pool of capital is available for investment in debt versus equity. By employing financial engineering techniques such as securitization, it can raise even greater amounts of more-patient capital. In a simulation using historical data for new molecular entities in oncology from 1990 to 2011, we find that megafunds of $5-15 billion may yield average investment returns of 8.9-11.4% for equity holders and 5-8% for 'research-backed obligation' holders, which are lower than typical venture-capital hurdle rates by attractive to pension funds, insurance companies and other large institutional investors. Open-source software available for download in link above.
Do Labyrinthine Legal Limits on Leverage Lessen the Likelihood of Losses? An Analytical Framework2012
A common theme in the regulation of financial institutions and transactions is leverage constraints. Although such constraints are implemented in various ways—from minimum net capital rules to margin requirements to credit limits—the basic motivation is the same: to limit the potential losses of certain counterparties. However, the emergence of dynamic trading strategies, derivative securities, and other financial innovations poses new challenges to these constraints. We propose a simple analytical framework for specifying leverage constraints that addresses this challenge by explicitly linking the likelihood of financial loss to the behavior of the financial entity under supervision and prevailing market conditions. An immediate implication of this framework is that not all leverage is created equal, and any fixed numerical limit can lead to dramatically different loss probabilities over time and across assets and investment styles. This framework can also be used to investigate the macroprudential policy implications of microprudential regulations through the general-equilibrium impact of leverage constraints on market parameters such as volatility and tail probabilities.
Estimating the NIH Efficient Frontier2012
The National Institutes of Health (NIH) is among the world’s largest investors in biomedical research, with a mandate to: “…lengthen life, and reduce the burdens of illness and disability.” Its funding decisions have been criticized as insufficiently focused on disease burden. We hypothesize that modern portfolio theory can create a closer link between basic research and outcome, and offer insight into basic-science related improvements in public health. We propose portfolio theory as a systematic framework for making biomedical funding allocation decisions–one that is directly tied to the risk/reward trade-off of burden-of-disease outcomes.
Finance is in Need of a Technological Revolution2012
The financial system has reached a level of complexity that only “power users” – highly trained experts with domain-specific knowledge – are able to manage. But because technological advances have come so quickly and are often adopted so broadly, there are not enough power users to go around. The interconnectedness of financial markets and institutions has created a new form of financial accident: a systemic event that extends beyond the borders of any single organisation.