The article “Modern Portfolio Theory, Financial Engineering, and Their Roles in Financial Crises” discusses modern portfolio theory, and the financial engineering. The author mentions roles that modern portfolio theory and financial engineering played in the financial crises. Also, the author states the issue of why elegant mathematics leads to bad polices. In this assignment, I will summarize most of the points that are discussed in the article.
The author begins the article by defining the concept of modern portfolio theory (MPT). Modern portfolio theory can be defined as a theory on how investors can have optimal portfolios that generate the heights expected return based on a given level of risk. In other words, it is possible to build efficient frontier of optimal portfolios that generate maximum expected return at a given level of risk. The article presents the optimization process in the theory by its inputs and outputs. The first inputs is the expected returns for each security, which can be estimated using historical returns. The second input is the covariance matrix that includes the correlation coefficient, the standard deviation, and the variance of each security. The last input is the constraints in the selection of portfolio such as the turnover of the portfolio or liquidity. On the other hand, the optimization process has to outputs. The first is the efficient frontiers that represent the risk-return trade-off portfolios. The second output is the choice of portfolio that has the risk and return optimization for the investor.
Financial Engineering (FE) is the second point that the article discusses. To fully understand financial engineering, we should understand the Black-Scholes-Merton (BSM), which is an option-pricing model. Some of the inputs of the model are observable such as stock price, interest rate, and expiration date. However, inputs such as standard deviation are not observable, it has to be estimated. The model assumes that the standard deviation will be constant or easily predictable, the stock price will not move vary high or low, and there are not transaction costs.
For the past 30 years, three financial disasters have occurred globally. Black Monday, Long-Term Capital Management, and the latest financial crisis were the most financial crises that harmed the economy of many countries in the world epically the US. Modern portfolio theory and financial engineering have partially caused these crises. As the article discusses each financial crisis and the causes of them, I will summarize each financial crisis and the roles that modern portfolio theory and financial engineering played in them.
Black Monday is on 19 October 1987 when the stock market went down. There were many causes of Black Monday and one of them is how financial engineering used Black-Scholes-Merton model to price options. One of BSM assumptions is that markets are always in time and always liquid, however, the assumption was not true. Call/put...