Don’t blame the quants, says Merton

Quantitative models were unfairly criticised in the aftermath of the financial crisis, says legendary quant and co-creator of the Black-Scholes equation, but there’s plenty for quants to work on in the current environment

The future for quantitative finance is bright, as practitioners apply it to new areas like systemic risk management and retirement provision, according to Robert Merton, professor of finance at the Massachusetts Institute of Technology, speaking in a video interview with Risk.

Merton also warns that models are only as good as the humans that operate them, and critiques elements of the Basel Committee’s fundamental review of the trading book capital rules.

Defending quants from critics that have sought to blame them for the financial crisis, Merton says: “Some have said ‘We’ve got to get the quants out and put in ‘sensible’ people’. If one had to point to errors, it’s much more likely you had people who were not well enough trained, who don’t understand all the intricacies of the models – and their limits – and who don’t understand the instruments they are overseeing or working with.”

He says the proliferation of explicit and implicit guarantees in the financial system in the run-up to the crisis in effect made taxpayers writers of exotic compound derivatives. Traditional macroeconomic models are ill-equipped to cope with this, and only quants can help, he argues.

“In the understanding of the macro-financial risk propagation, the sorts of things that create financial crises…with no disrespect to my macroeconomic colleagues, the sorts of models used to understand this were never designed to incorporate uncertainty structurally – they had uncertainty built in as an afterthought,” he says. “We know from finance, from [Merton’s corporate debt model] how to understand that.”

An in-depth feature on the future of quantitative finance will appear later this month as part of a special supplement marking Risk‘s 25th anniversary.


This article was first published on Risk

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