Thursday, 5 February 2009

Do the maths

In a week that has seen the disappearance from the financial landscape of such venerable firms as Lehman Brothers, Merrill Lynch and the Bank of Scotland it is inevitable that people question the competence of bankers. Along with many financial mathematicians, in both the financial industry and academia, I take the view that if you give people who have only ever driven bullock carts, Ferraris, they are likely to end up in a ditch. The people running the banking industry have not had a firm grasp of the technology underpinning their business.


Financial mathematics supports the practical disciple of constructing financial products in the same way that mechanics and thermodynamics supports motor engineering. Derivatives, the products that financial mathematicians construct, transfer risk in financial markets just as engines transfer energy in the physical world. Fixed rate mortgages are a popular product of financial mathematics, the borrower passes the uncertainty in the future interest rate to the lender, who takes it on for a fee. Just as in any industry, most people working in the financial markets are involved with the sales and servicing of products and only a few people actually design, and so have a deep understanding of, the products themselves. Jeremy Clarkson does not need to understand automotive engineering to be considered an expert on cars.


It is not surprising that many bankers did not understand the science they work with, because financial mathematics is literally rocket science; it comes directly from the mathematics developed in the fifties and sixties to control rockets. The international investment banks are well aware of this and they are becoming less interested in recruiting graduates with a degree in economics from the LSE, who understand theory, and are more interested in engineers, physicists or mathematicians, who can do the complex calculations underpinning derivatives. This is nothing new, for around a decade the most popular destination of physicists on completing their PhDs has been The City and more graduate engineers in the UK now head for careers in finance than in engineering.


Although young British scientists can contemplate fat salaries with investment banks, they are at a disadvantage. If you visit the sharp end of a City firm, you will notice that there are a large number of continental graduates working there. This is no accident; continentals have a much better education in probability than UK graduates. The reason for this is cultural. The UK was at the heart of the development of statistics in the nineteenth century but at that time most mathematicians thought statistics heresy, because it is inductive rather than deductive, and today most UK universities still have separate maths and statistics departments. Seventy-five years ago this summer, a young Russian mathematician Andrey Kolmogorov defined probability in terms of rigorous mathematics placing probability firmly in the mathematics syllabus taught at school and through university in the rest of Europe.


There is a conceptual gulf between British and French graduates. When using probability to think about the future, English speakers will talk about an expectation, the French talk about an esperance, which is associated with 'hope'. The British and American bankers expect something, the French hope for it. The bankers creating asset-backed securities believed that they had removed risk because they lacked a real understanding of probability. If we want to maintain our position in the lead of finance, we need to train more people in probability so that they are better able to deal with an uncertain future and look after our money.

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