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Financial Innovation and the Future of Risk

 

I recently had the opportunity to attend a talk by Dr. Robert C. Merton, of the Sloan School of Management on the title topic. Dr. Merton spoke at the invitation of The Chicago Council on Global Affairs, with sponsorship by the CME Group.

 

For those for whom the name might not be familiar, Dr. Merton was a co-winner of the 1997 Nobel Prize, along with Black and Scholes, for the development of the Black-Scoles-Merton model of options pricing.. On a more somber note, he was also one of the founders, and served on the board of Long Term Capital Management.

 

More recently, (in 2007), he became Chief Science Officer for Trinsum Group, a financial advisory firm. To quote from Wkipedia:

 

“On January 30, 2009 Trinsum Group put the following press statement on its website,

"Trinsum Group, Inc., a holding company, announced this week that it has filed a voluntary petition under Chapter 11 of the Federal Bankruptcy Code in the United States Bankruptcy Court in the Southern District of New York. The Chapter 11 proceeding does not include the Company's operating subsidiaries, including its consulting subsidiary, and their operations will not be affected.
During the past several months, the Company had explored a number of alternatives to strengthen the Company's financial base, resolve certain legal issues, and dispose of non-core businesses outside of Bankruptcy. Despite some progress, the Company concluded that the Chapter 11 route provided the most efficient mechanism to achieve its goals with minimal disruption to each of its businesses.
"We have come to the conclusion that our businesses are better off as focused and independent entities," said James McTaggart, current Chairman of Trinsum. "The goal of the reorganization is to separate each of these businesses in order to permit each to continue to operate independently of one another as strong and focused concerns."

Now, it seems that Dr. Merton has focused his attentions on the not insubstantial problem of corporate pension under-funding. Using charts sourced from “The World Market Portfolio”, by Andre F. Perold and Joshua N. Musher, published in 2002, Dr. Merton compared the risk/return profiles of different portfolios. Naturally, an all Treasury portfolio was very low on risk, with correspondingly low returns. On the other hand, a more “typical” portfolio with an 85% equity/15% Treasuries showed substantially higher returns, but of course, with much greater risk. I would have been interested to see how the numbers would have looked, had the end date would have been more recent…say up to 2009.

Once a quant, always a quant, I guess, because Dr. Merton’s solution to narrowing the gap between the returns of is, ….you may have guessed it, …. derivatives. His prepared remarks was followed by a Q&A session, and I dearly would have loved to learn how his proposed solution would deal with counter-party risk, the current Achilles heel of derivatives. Unfortunately, I was not able to pose my question.

One solution I’ve heard being bandied about as a solution to that problem, is the creation of “standardized” contracts that would be traded on an exchange. The sharp reader might have noted that the talk was sponsored by the CME Group, and in his prepared talk, Dr. Merton let “slip” that he was working “certain parties” (that was the phrase I recall that he used) on such a product.




Disclosure: No positions