New directions
for fi nancial theory
Lucio Sarno, James Sefton, and Steve Satchell discuss the impact of
market events on fi nancial theory, and look at where innovation
will come from in the future
TAPLEY – What will be the impact of Th ird, the increased integration of However, and more fundamentally,
the fi nancial crisis on fi nancial theory?
fi nancial markets requires re-thinking of the academic profession needs to
popular theoretical models of address a more endemic problem. Over
SARNO – I can see at least three areas of diversifi cation. Th e crisis has shown very time research has become more
fi nance theory that will be impacted clearly that in bad times all risky assets can specialised, with individuals becoming
seriously. Th ese have to do with become highly correlated, and experts on more and more tightly
standard assumptions in canonical diversifi cation fails exactly when it is defi ned areas. At a very basic level, for
fi nance theory and asset pricing: the needed most. Modelling accurately this example, there is the division between
idealistic notion that markets are time-varying, regime-dependent asset pricing and corporate fi nance
self-correcting; mean-variance rules in correlation of asset prices across both theory: the former ignores incentives
asset management; and the belief that countries and asset classes will occupy the while the latter focuses on little else. To
diversifi cation is straightforward to attention of scholars for years to come. understand the current crisis,
achieve. First, pricing models for researchers need to straddle both fi elds,
fi nancial instruments are generally built SEFTON – Th e fi nancial crisis has ignoring the accepted assumptions in
in partial equilibrium settings and already shifted the emphasis in the each area. Th is requires a virtual U-turn
under the assumption that price research agenda. Th is is happening in the way research is approached, and
convergence to fundamental value just relatively quickly and organically as is therefore unlikely to happen.
happens naturally. Th is is simply not various topics become both more
the case. One can debate whether any ‘fundable’ and more ‘publishable’. We SATCHELL – Hopefully, we will move
government has responded adequately have already seen a ballooning of away from the sort of extended mean-
to the crisis, but nobody will argue that research into liquidity – both funding variance, CAPM approach popular in
the market continues to believe that and trading liquidity – which has business schools and MBA programs. In
only governments can lead the market always been a rather neglected area in this world you can gear your position as
to restore its basic functions. the past. One would also expect that much as you like without having any
Second, there is a genuine need to housing as an investment will receive impact on bankruptcy risk. It leads to
generalise mean-variance analysis to far more attention, as well as the simple and elegant mathematics but is
allow for a richer characterisation of apparent lack of diversifi cation across pernicious in terms of sweeping the real
risk than simply looking at standard asset classes. risks under the carpet. If this was only a
deviations of returns. Until now,
research on non-linear dynamics of
“Hopefully we will move away from the sort of
asset prices and extreme-value theory
have been sidelined as too sophisticated
and unlikely to be of any practical
extended mean variance, CAPM approach
importance. Th e result is the
underestimation of risk that has popular in business schools and MBA programs”
dominated the best part of the 15 years
prior to the crisis.
SATCHELL
6 SUMMER 2009
08-1108-11 academic roundtable.indd 6academic roundtable.indd 6 1/6/091/6/09 11:25:3711:25:37Professional Investor Summer 09.8 8 4/6/09 15:40:43
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