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June 16, 2008 1:09 am

John Hull: Cautious of creating too much complexity

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John Hull has a confession to make.

As a professor of finance at the University of Toronto’s Rotman School of Management, he has won international acclaim for designing and valuing complex financial tools such as options and other derivatives.

But when it comes to managing his own money, Prof Hull has little use for such exotic instruments. His investment portfolio comprises mainly index funds. And while he keeps reminding his students about the importance of hedging risk, his own liabilities are heavily concentrated in Canadian dollars.

“In retrospect, I certainly haven’t behaved optimally,” the 62-year-old, UK-born professor says with a wry smile.

Seen from a different angle however, Prof Hull’s financial strategy is entirely consistent with the message he hammers home as a teacher, author, consultant and expert witness in derivative-related lawsuits: that is, keep things as simple as possible.

“There’s a danger, with all the people with PhDs in physics and maths who have moved into this area, that some of the models become too complicated”, Prof Hull says. “There’s a tendency for people with that sort of background to just want a really difficult problem to solve. And that’s not necessarily what’s needed.”

His avoidance of this tendency helps explain the respect his work has garnered.

Izzy Nelken, president of Super Computer Consulting in Chicago, who has known Prof Hull for 16 years and co-authored several publications with him, notes that while “some folks like to couch it all in huge mystery, John doesn’t do that. He always brings the latest developments in a simple, easy-to-understand manner.”

Armed with a Cambridge maths degree, Prof Hull’s first job was in operational research at a UK shoe manufacturer.

An interest in applying mathematics to finance led him to do a PhD at Cranfield University.

He had his first taste of Canada as a visiting lecturer at the University of British Columbia in Vancouver in 1979. He then moved to York University in Toronto two years later so he could work in a leading financial centre. He has been at Rotman since 1988.

Quantitative analysis and analysts have made deep in-roads in trading rooms and financial research departments since two University of Chicago economists, Fischer Black and Myron Scholes, devised a mathematical model for pricing options and corporate liabilities in the early 1970s.

However, the recent turmoil in financial markets has jolted faith in the so-called “quants”.

Prof Hull agrees that “there’s some ground for concern” that traders and analysts have relied too heavily on mathematical models in their decision-making.

“We need a much more common-sense approach to risk management and must not let quants and traders run free-rein for short-term profits,” he says.

The problem, in Prof Hull’s view, has been an overdependence on models that are based chiefly on recent market trends.

Over the past three years, for instance, “we were looking at a period when volatilities were very low”, he says, “so values at risk were lower”.

“To some extent, that model led to a false confidence on the part of the banks. Somebody should have been saying: ‘Let’s look at the big picture, what could go wrong? How well will we come out if it does go wrong?’

“In most institutions I don’t think anybody was doing that. They were just relying on: ‘We’re making a lot of money, the value-at-risk model says we’re okay’.”

But heavy losses since the onset of the US subprime mortgage crisis have prompted a good deal of soul-searching among quants, and those who employ them. “I don’t think there is a substitute for sound managerial judgment,” Prof Hull says.

“In a few companies, however, rather than senior managers letting the traders run loose on this, they sat back and thought about the environment out there; about what could go wrong and how badly they would suffer if it did.”

As for his own approach, he says that “my claim to fame is not being an out-and-out quant.

“It’s more looking at a situation, coming up with the simplest model that captures the essence of it, and then writing it up in such a way that people will easily be able to understand it.”

His seminal book Options, Futures and Other Derivatives, now in its seventh edition, is widely regarded as the bible of the subject. According to Mr Nelken, “he’s had a substantial impact on a whole generation of financial mathematicians”.

Prof Hull tries to bring equations to life by including actual figures in them. His books are dotted with “Business Snapshots” that show how quantitative theories and models are applied in real-life situations.

His books also demonstrate his appreciation of the shortcomings, as well as the advantages, of exotic financial instruments.

For example, the chapter on asset-backed securities in the latest edition observes that these financial products have been created from exotic assets such as royalties from the future sales of a piece of music.

“Dealers have been very creative – perhaps too creative – in their use of this type of structure,” he concludes.

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