Wednesday, May 13, 2009

What Good Is Modern Finance

Many, particularly the media and elected officials, blame financial institutions and new, sophisticated products for the current financial crisis. Congress will look to pass legislation to increase the oversight of derivatives and financial intermediaries. Additionally, there is the prospect of new regulations for the firms in this industry.

Modern finance added something to the traditional methods of finance. It improved banking, corporate governance and investment risk management. However, it is not foolproof.

A primary objective of modern finance is about improving efficiencies of capital markets, by lowering the costs of raising capital and investing. Modern finance is also descriptive, mathematically and economically.

Modern finance shows why for example owning no load, low expense ratio mutual funds with holdings in a wide breadth of industries is safer that putting all your money in one company and why the low cost fund gets better returns than a fund with high investor expenses. By the way, mutual funds are more than stocks and bonds. Investors buy participation in an entity that owns investments, such as stocks and/or bonds. They are very similar to mortgage back securities, or collateralized mortgage or debt obligations.

Modern finance also allowed the development and issuance of TIPS, US Treasury inflation protection securities. These securities do not lose value if future inflation increases.

A few of the theories that allow for these improvements are the Black-Scholes-Merton option and contingent claim pricing model, the Sharpe-Lintner capital asset pricing model, and Markowitz mean-variance. There are also many other significant concepts, theories and research in other important areas of modern finance that have also helped in improving banking, corporate governance and investment risk management. Such as work by Akerlof, Spence, and Stiglitz on information asymmetry in markets. Work by Samuelson and Fama on efficient markets and many others in many other important areas of finance.

The ability to lower the costs of issuing debt or equity has been one of the most important benefits of modern finance. It also includes lowering the costs of obtaining information, including information about risk, about debt and equity that has tremendously benefited our economy. The lower cost alternatives to traditional banking has been the reason high cost banks' market share of corporate financings has decline significantly since 1950.

Improvements in information about debt and equities include improvements in corporate governance. While the public, a populist president and populist elected officials may object to high corporate salaries, bankers and corporate bondholders could stop this practice almost immediately if they felt it was a cause of concern about either the business health of the company or the company's ability to meet it debt obligations. I do not believe there is a single debt covenant in any public company's loans or bond agreements that prohibits competitive salaries to senior management. If these high salaries did broad based economic harm to our economy in other ways, every corporate bond covenant would have a clause prohibiting the practice to protect bondholders to reduce the risk of an economic downturn and the corporate inability to pay debt holders.

Derivatives exist because they are lower cost than alternatives to these types of transactions. Without options, one would have to use futures, which are more expensive because they require purchasing the underlying. Without futures, one would have to use forward contracts, which are even more expensive than futures. Without forward contracts, one would need partners or vertical business integration.

As an aside, mutual funds use a tiny portion of their funds to buy some options or futures that mimic the fund, to offset the zero return of cash they hold to meet redemptions or they have received from investors but they have not yet been able to invest.

The most surprising thing about the topic of the benefits from modern finance is how much knowledge macro-economists will impart about general equilibrium, GDP, Keynes, etc., but how little of their knowledge ( I presume) they have about capital markets and derivatives they are willing to show. For some reason, many macro-economists become populists and resort to public perceptions instead of financial economic wisdom about markets.

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