Anyone following Nouriel Roubini through his time during the Asian Currency crisis over a decade ago* must be aware of the similarities between that and the one we are currently experiencing. Roubini has been interviewed recently and shared his thoughts: "The U.S. has been living in excessive spending for too long. The consumer was spending more than their earnings, and the nation spent more money than it earned which led to huge current-account deficits. We now have to cut our spending as well as save more. The issue is that greater savings over the long term are a good thing, but in the short term, the reduction in consumption of consumers causes the economic recession to become more serious."

That's the irony of thrift. However, we must save more as a nation and allocate more resources to sectors in the economic system that can be more productive. You've got problems if you're surrounded by excessive financial engineers but not enough computer engineers. ......I believe this nation needs more people who want to become entrepreneurs, more workers working in manufacturing, and more people going into industries that will bring long-term economic expansion. Suppose the top minds of the country are all headed towards Wall Street. In that case, there is an unbalanced allocation of human capital into certain tasks that can become overly expensive and ultimately inefficient." But, Nobel laureate Robert Merton from Harvard Business School has a distinct view:

We require increased financial specialists, but not fewer risks and innovations, such as derivatives. They will not go away. We require boards, directors, and financial institutions' regulators to be aware of these issues." Are they Financial Engineers? And what are They Discussing? I earned the Master in Science of Financial Engineering degree back in 2002, and to this day, nobody knows what it signifies. Okay, Financial Engineers are often "rocket scientists" (literally) who are employed by banks of all sizes and multinational corporations to develop sophisticated mathematical models to determine the probability of events that could be risky, to offer valuations of instruments that are usually difficult to value, and to design synthetic securities to mitigate the purpose of hedge risk (and sometimes to speculate).

"As L.B.O. specialist Ted Stolberg once stated in Inc. Magazine, 'Financial engineering is like making bridges. It can be built in any way you want, as it doesn't fall when trucks can pass over it. And you can build additional lanes whenever you need more traffic to pass over it. When it's done, and it's finished, it's an impressive sight as its counterpart, the Golden Gate'" (Warsh 1993, 296). 296). The "quants" who are affectionately referred to are frequently lured away from the low paying academic jobs of Wall Street to high paying jobs in London, New York, Chicago or California. Corporate executives who hire these Quants frequently inform their clients they will all be fine due to the genius minds they are now on their payroll. However, there are two major issues in finance that have been discovered in hindsight. The first is that finance is all about humans and their relationship to one each.

Real-world finance has little to do with the logic of maths and physics. Many finance models begin by assuming "Homo Economus", which implies that humans are rational beings. It is an incorrect assumption due to the recent study of cognitive neuroscience. In addition, decision-makers in higher management can misinterpret the output of the financial models. Alfred Korzybski said, "The map isn't the real territory". Many decision-making is based on these models, which have given them far too significant weight. Senior executives are eager to affirm their achievements and deflect their mistakes. It is human nature to be human, after all. Finance Models: Stock Market Rationality or Irrationality? "It can be more than just a metaphor to define the system of price as a form of machine or technology that allows individuals to monitor the movements of a few indicators, much like an engineer would look at the hands of a few dials to adapt their actions to the changes which they will never be aware of more than what is evident in the price movements." - F.A. Hayek, The concept of the efficient market hypothesis, is very appealing both the way it is conceptualized and applied that is the reason for its longevity of popularity.

In a nutshell: effective stock markets are typically described as equilibrium markets where the prices of securities are reflected in all pertinent information accessible about the "fundamental" worth of the security (Tangentially, Benjamin Graham, well-known for co-authoring Fundamentalist Treatise Security Analysis with David L. Dodd was quoted as saying just before his death that "I have ceased to be an advocate of complex techniques of security analysis to discover more value-for-money possibilities... I am not sure that such an in-depth analysis will yield enough superior options that justify their cost... I'm in the camp of the "efficient market" method of thinking ..." (Malkiel, 1996, 191 p. 191[Malkiel, 1996, p. 191]). Despite its popularity, the efficient theory of capital markets has endured some of the most appropriate criticisms. Because a theory accurately represents reality rather than "reality" itself, theories may have anomalies when they don't reflect reality, as the concept of efficient capital markets isn't an exception.

Ray Ball's article, The Theory of the Stock Market Efficiency Achievements and Limitations (Ball 1994 40, p. 40) offers a mostly well-balanced perspective and reveals several interesting anomalies: 1.) A study conducted by French and Roll suggests that prices are overreacting to any new information that is followed by a correction that allows investors who are not in the market to make profits. 2.) Price volatility is excessive because of the "extraordinary beliefs and the craze of the crowds". 3.) Prices are not responsive to quarterly financial reports. This is an oddity when it comes to prices' tendency to react too strongly to the release of new information. 4.) An analysis conducted by Fama and French shows that there isn't a connection between the historical betas and the historical returns, which has led many to believe that the equilibrium-based CAPM was developed because of the huge quantity of empirical evidence on efficiency not working. (Not mentioned in Ball's article and the story by Malkiel in his book A Random Walk Down Wall Street is the tale of the way Fama and French discovered that investing in stocks that have been performing poorly over the last two years can often bring the investor above-average returns over the following two decades (Malkiel, page. 198) which allows those who have been naive to profit again.) 5.) It is possible to identify seasonal trends seen in the data of the returns of stocks or smaller firms like the "January effect," where stock prices are unusually high, or the "January effect" in which stocks are notably higher in the initial few days of January, or"the "weekend effect" when average returns for stocks negatively correlate between closing on Friday and the close on Monday.

In Ball's article, there are some omissions. These include 1. The evidence suggests that companies with low P/E ratios perform better than the ones with higher ratios of P/E. 2. Evidence shows that stocks sold with low book-value ratios are more likely to yield higher returns. 3. Evidence shows that stocks with higher initial dividends tend to have greater returns (Malkiel in pp. 204 -207). The main area that sets Ball's work apart from other reviews of the difficulties and triumphs in the study of efficient capital markets is in a chapter that is titled "Defects in the concept of 'Efficiency' as a model of Stock Markets" (Ball, p. 41-46) in which he discusses the widespread neglect in research conducted on the theory and the practical aspects of the effectiveness of the stock market in the processing and acquisition cost of information. This lack of attention may be the cause of the irregularities, like the "small firm effect ", small effects of the firm", or the tendency of small-cap stocks to yield more returns. Ball also challenges the notion of the efficient markets hypothesis of investors "homogeneity" and recommends that there is a need to develop a new research program. Ball is also concerned about the significance of both transaction costs and their impact on the theory of efficient markets as "largely not fully understood" and the impact of the market mechanism itself on the prices that are transacted which is also referred to as "market Microstructure Effects".

He defends the efficient markets theory against Robert Shiller's arguments (that the historical variation of stock prices was significantly more volatile than could be justified by the historical variance of real dividends) by disputing Shiller's assertion of a consistent market expected yield in nominal values. Because CAPM is based on a constant risk-free rate of return and an unchanging market risk premium, it is difficult to establish the "correct" quantity of variation for the market gauge. The Ball is also defending market efficiency against Shiller and other behavioralists, affirming that the mean-reversion in stock returns doesn't necessarily suggest market irrationality. CAPM does not claim to discredit the tendency for periods of very high returns followed by periods of low returns. In reality, these pattern patterns could be an outcome of rational responses of investors to economic and political conditions and corporations to changes in demands for stocks.

Ball gives more room for Shiller and the behaviourists when he concludes his article with the question, "Is behaviour-based finance the solution?" He quickly responds, "I don't think so" (Ball, page. 47). I'd change the question to "Does behavioural finance give valuable answers?" And my answer would be "yes." Whether or not investors act rationally or whether or not they correctly maximize their expected utility is an essential assumption in the efficient market hypothesis. And if it isn't accurate, it could be why there are anomalies. Prospect theory research by Allias, Kahneman and Tversky offers a compelling argument that suggests that the conventional theory of anticipated utility maximization as formulated by the majority of financial economists might not accurately represent human behaviour (prospect theory claims that individuals are best represented as maximizing a weighted sum of "utilities," determined by an equation of probabilities which assign zero weight to very low probabilities, and a weight that is one for extremely strong probabilities). Although the evidence isn't shocking, it is alarming, to not least (Shiller 1997).).
The article Ball does not follow the usual method used by financial economists to divide the theory of efficiency of stock markets into three categories that range from the least to the most conventional, are as below: 1. The weaker form says that the history of the price of stocks has insufficient information to enable investors to beat a buy-and-hold portfolio management model consistently. 2. The semi-strong version states that there isn't any published data that will aid security analysts to select "undervalued" Securities. 3. The strong form states that everything that is known or information about a business can be seen in its stock price. Statistics lend credibility to these weak, semi-strong versions and the stronger version that claims that insiders incorporate have made huge profits using insider information. To support both the semi- and weak variants, the findings of Ball as well as Brown's late 1960s analysis (Ball and Brown, 35. 35) of how the market reacts to announcements of annual earnings indicate markets anticipate around 80 per cent of the new information that is revealed in annual earnings, even before the actual announcement of earnings.

That is to say; investors were largely left with no opportunities to make money from the new data since the market had already processed the data published within the earnings report for each year. I believe that investors and "Quants" alike should be careful to avoid swallowing any approach in its entirety, warts included, and instead be aware of the strengths and weaknesses of every approach. In the realm of scientific research where Quants feel the same level, there aren't successes or failures, just results or outcomes. Data points emerge that will tell whether your hypothesis is true or not. However, when you make an "experiment" in the world of capital markets, it can be leveraged to the point of being a risk. It can cause the bankrupting of entire nations and, in the present, maybe even the entire world. In the capital markets, the actual risk of experiments could result in people eating less. What is a risk, and where is Financial Engineering playing a role? It is easy to conclude that there is a positive correlation between uncertainty and risk. The more certain are of an outcome more secure it can be. But in a fast-paced world like ours, in which we're unable to (and generally incorrectly) determine the weather for five days in the future, How could a financial planner, farmer, financial manager, or other concerned party be expected to know what the price for tea in China weeks or months or years in the future?

The beautiful asymmetric nature of a particular financial instrument known as an "option" is evident: "A call option is to purchase an amount of a specific fundamental asset for an agreed-upon exercise price at or before the expiration date. A put option gives you the option to sell a specific amount of an underlying asset at an exercise price specified at or before the end date" (Figlewski and Silber 1990, p. 4.). The premium amount can limit a person's risk, and the profit potential is unlimitable. While it's impossible to know the exact cost of tea within China, it is possible to establish a ceiling for losses that are allowed to occur without putting limits on the profit earned. Options are part of a category of financial instruments known as derivatives. They are so named because they are derived from something other than. Options, for instance, are derived from an asset that is the basis for their value. Other derivatives include swaps and exchange rate futures that are valued based on the exchange rate and interest levels (some people exchange cash payments obligations because they prefer another payment source) and commodity futures, which value is based on the prices of commodities and forward contracts that are similar to future contracts with the exception that the product in the contract is delivered at a certain future date. However, how do we utilize these instruments to limit our risk?

"Financial engineering refers to the use of financial instruments to transform the existing financial profile to one that has more desirable characteristics" (Galitz 1995 Galitz, 1995, page. 5). It is the job of the finance engineer to develop "synthetic" securities that will achieve the desired risk-return outcomes. It is possible to combine the options swaps, futures, swaps and so on. and make new securities to protect against the risk of unforeseen events. If there is a comparable cash flow between both securities, any variation in the current market value of the two securities is an arbitrage opportunity. Arbitrage is a type of trade where one purchases an item at a certain price. It sells it back to identical items at a higher cost to earn an unrisky profit (In the case of a market that is efficient, such opportunities will be very, extremely rare, and if the clever investor seized advantage of it, the process would drive the cost of what they are purchasing as well as the cost of the product they are selling down).

A simple example of how Financial Engineering Works In his article The Arithmetic of Financial Engineering (Smith 1999, p. 534), Donald J. Smith utilizes basic algebra and arithmetic to show the interrelations of various combinations of security (synthetic securities) that financial engineers use to design these distinctive risk-return trade-offs. The formula he uses to explain his basic concept is as follows: A+B = C A and B are the constituents of this synthetic portfolio.. the straight security. A + refers to a long position, a lending position the - sign indicates a neutral position or a borrowing stance. Using the above formula, Smith can illustrate the relationships of these synthetic securities, such as Interest rate swaps and interest rate swap = Unrestricted Fixed-Rate Note - Fixed Rate Note. The coupon of most bonds is fixed in advance and hence the term fixed-income securities. However, some issues come with coupons that reset regularly and float. These are known as floating-rate notes.

Collars + Collar = + Cap Floor "Caps" and "Floors" are options agreements that ensure the highest [Cap] as well as the minimum [floorrate that is attained. Floors and caps are insurance contracts for interest rates that protect against losses resulting from the rate of interest rising above or below the specified levels. Mini-Max Floater + Mini Max floating rate note = Common Floating Rate Note Cap Inverse Floaters - inverse floating Floater = two fixed-rate notes Unrestricted Floating Rate Note-Cap Inverse floaters are a great choice for investors who are optimistic about bond prices and are expecting rates to fall. This is the fake investment the infamous Robert Citron used wrongly and resulted in the bankruptcy of Orange County, California, when the Federal Reserve sharply raised interest rates in 1994. This error cost Orange County $1.7 billion in dollars in 1994! Participants Agreements and Participation Contract = + Cap - Floor simple formula is a great source of explaining ability for those seeking to understand the intricate financial engineering.

But the financial engineer has to be wary of dual-edged weapons that are derivative instruments. If used for hedge purposes, they can provide invaluable safeguards against risk; however, when used for speculation, they could invite risk that is not needed. In addition, hubris can be destructive as payouts are too complicated to comprehend fully. Unintentional consequences can be unpleasant (see Credit Default Swaps). This is the case with The United States Government = The Paleo-Financial Engineers. "Blessed are the young because they will inherit the nation's debt" Herbert Hoover. Let's examine some of the largest and most complex financial engineering strategies ever devised—the relationship between the United States Treasury and the Federal Reserve system. Federal Reserve is a privately owned corporation. Federal Reserve is a privately owned company. Also, according to the popular saying, "The Federal Reserve is just as federal as Federal Express". The top stockholders of the Federal Reserve bank are the largest. Federal Reserve bank is one of the 17 biggest banks in the world. In fact, for this century, the United States the last century was one of deficits and debt.

Said, a deficit happens whenever you pay more than you can afford. Each time the government is forced to spend more than it can afford, it must make a loan, or I.O.U., usually a U.S. Treasury bond, to pay for the expenditure. This is because the Federal Reserve banking cartel buys these bonds (with paper currency made out of thin air) in the hope to pay back to the Federal Reserve back both the principal amount and a set amount of interest. For this, the Federal Reserve creates money (mostly electronically and entirely from the air) by manipulating ledger accounts. People do not understand that the primary method Treasury generates funds to pay its obligation in its Federal Reserve is through taxation. In simple terms, the money we earn through taxes goes directly to banks. One more alarming fact is that to understand the amount this U.S. owes to bondholders (i.e. those part of the Federal Reserve banking cartel), look at the National Debt. It's over $11 trillion (remember trillion is the million-dollar amount, billion is one thousand million, and a million is one thousand.
With an estimated population in the United States of 305,367,770, every United States citizen's share of the debt owed to the public is around $40k as of this writing. The problem is If the increase in the debt is steady and is higher than the rate of increase of the average real income, then what do you expect from the state when the tax revenues aren't enough to cover the interest of the debt? After that, the money (again, that was made out of thin air) is absorbed in the economic system, the government uses it and then flows back to private banks. Then, the real inflation is created by the magic that is fractional reserve banking. The process is explained within the Federal Reserves' manual known as "Modern Money Mechanics". In short, because they only have a small portion of the reserves they have (while the ledgers of their accounts falsely state that they have all the money), the currency's value is inflated. The possibility of bank runs is always present.

There are three immediate actions that the government has the option of taking: repudiate, increase the rate of inflation, or liquidate. I am in favour of the liquidation of assets of the government (non-essential property of the government, such as those of the F.D.A., F.C.C., or the I.R.S.) over the possibility of hyperinflation or repudiation simply because liquidation of government assets is the best method to end the big government as we have it. Repudiation could cause a shock to the economy, and the interest rates would explode, and bond prices could fall; there's a risk too high. Inflation will only reduce the currency's value and make it more expensive for everyone involved. All this brings me full circle back to Nouriel Roubini's quote: "The U.S. has been in a state of excesses for a long time. Consumers were spending more than their earnings, and the nation had a higher spending rate than it earned, leading to large current-account deficits. We now have to tighten our belts to save more. The problem is that greater savings over the long term are beneficial; however, in the short term, the reduction in consumption of consumers causes the economic recession to become more serious.

That's the contradiction of thrift. We need to save more as a nation and redirect more money to areas within the market that can be more productive. There is an issue if you're surrounded by excessive financial engineers but fewer computer engineers. ......I believe that this country requires more people to become entrepreneurs, more workers working in manufacturing, and more people going into industries that will bring long-term economic expansion. Suppose the top minds of the country are all headed into Wall Street. There is an imbalance in the distribution of human capital into certain activities that become too much and then inefficient." I am completely convinced that the answer is in entrepreneurship. Still, the concept of "excess" follows the quote. It ties it with our current economic crisis. Who are the real creators of this excess, those who are the Financial Engineers alone or are the Federal Reserve and the U.S. Treasury also involved?
REFERENCES Hayek, F. A. (September 1948). (September 1948). Use of Knowledge in Society.

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