Twofish's Blog

October 15, 2008

What are the important questions in finance?

Filed under: china, finance — twofish @ 2:31 pm

If you ask enough questions and design an experiment well, you get answers. If enough people ask the right questions, you can make a huge amount of progress.

So what are the important questions right now:

1) How will current events affect currency values and flows?

2) How will current events affect balance of trade?

3) How will the Chinese economy react to current events?

4) More regulation seems to be a given, but what needs to be regulated?  How does it need to be regulated?  Who does the regulation, and who regulates the regulators?

As far as quantitative finance:

1) What are some of the fundamental assumptions that we were mistaken about? 

One of the assumptions I think is questionable is the whole idea that you can put a single price to any derivative instrument.  Putting a single price to an instrument implies the ability to see into the future since the price of the instrument depends on unknown and perhaps unknowable events.  Also how do you deal with the situation in which the tail wags the dog, and prices influence markets more than markets influence prices.

I think a lot of the way we look at derivative instruments incorporate some of the philosophical assumptions of neoclassical economics, and those assumptions I think have broken down.

How do you deal with illiquidity and feedback mechanisms?

The other thing that I think needs to be done is to rethink how we deal with disasters.  One industry that has learned a lot from disasters is the airline industries, and the fact that you can get into a plane and fly involves a large amount of social structures and experience.  One thing that you learn in the airline industry is that “blame and punish” really doesn’t work that well in disaster prevention.  Disasters are the result of complex social interactions, often involving people that do what seem to be reasonable things, and a “blame and punish” mentality, while feeling good, really doesn’t help in getting safer airplanes since everyone ends up blaming other people and trying to avoid blame, and nothing gets done to improve processes or understand really what happened.

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