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The rebirth of financial engineering over the past few years has been every bit as striking as the returns once promised by some of the discipline’s more daring adherents.
Not that long ago, it looked like it was game over for the field of study that produced the mortgage backed security, the credit default swap and all manner of other exotic derivatives that exploded so spectacularly in the financial crisis of 2008.
Now, financial engineering theory is being touted by several academics as the key to curing cancer faster, reducing the impact of climate change and imposing better risk discipline on the same banks that were once almost felled by the discipline’s creations.
Graduates are flocking to specialist courses in record numbers, with Columbia receiving more than 1,200 applications for a course that has fewer than 90 places, and Cornell attracting more than 1,000 applications for a course with just 55 spots.
“It was Warren Buffett who said derivatives are financial markets’ weapons of mass destruction,” says Andrew Lo, the MIT Sloan finance professor and hedge fund manager behind pioneering work on how financial theory can help cure cancer.
“Uncontrolled use of these kinds of weapons could be extremely devastating and create nuclear fallout for decades . . . If we use these powerful tools responsibly and in a controlled way, the power they can provide is virtually unlimited.”
Mr Lo has spent years looking at how the principles of financial theory can be applied to fighting cancer. “In cancer drug development, because the risks of failure are so high, the probability of success goes up quite dramatically if you create a portfolio,” says Mr Lo.
He adds that the historical probability of success for developing a single anti-cancer treatment is about 5 per cent. But the probability of success shoots up to 99.59 per cent in a portfolio of 150 cancer drugs whose successes are statistically uncorrelated. That 99.59 per cent is not just the probability of one drug succeeding, it is the probability that two or more end up approved by the US’s Food and Drug Administration.
Size of UBS oncology fund
With financial pay-offs for each success potentially yielding billions of dollars, Mr Lo believes investing in cancer drugs on a large enough scale is safer than focusing on one long shot. Mr Lo bases his research on binomial distribution — a probability theory that looks at the distribution of outcomes from a repeated test — and basic portfolio theory, which advocates the benefits of holding a group of complementary assets. Mr Lo cites UBS’s recently launched $470m oncology fund as a real-life example of portfolio theory.
Another example of financial engineering put to broader use is Bob Litterman’s work on climate change. Mr Litterman, Goldman Sachs’s former head of risk who now works at hedge fund Kepos Capital, has studied how asset pricing theory can be applied to the true price of carbon.
He has concluded that carbon is massively underpriced, and that we are on course for a sharp, painful correction. He believes more work between climate scientists and financial modellers is needed to understand how carbon should be priced.
“They [economists] haven’t taken the science very seriously in projecting damages and in particular in projecting the full possible distribution of damages [from climate change],” Mr Litterman says. “The bottom line is these economic models can give us the social cost of carbon from $2 a tonne to several hundred dollars a tonne,” he adds, citing an Intergovernmental Panel on Climate Change report.
Some investors are already positioning for the correction, including the World Wildlife Fund, of which Mr Litterman is a director. The fund has bought a derivative that swaps the total return on an index of carbon-heavy assets like coal, tar and expensive sources of oil for the total return on an index of the S&P 500. The value of the swap has risen by 73 per cent since it was created by the WWF’s advisers, Cambridge Associates, in 2014.
Peter Carr, chair of New York University’s Tandon finance and risk department, says financial engineering can be applied to anything systemic or pervasive. He cites the examples of predicting weather patterns and human responses to drugs. His students are using financial engineering to look at banks’ systemic risk. “Financial engineers are already well trained to understand what values are going to be in the future,” he says. “That’s valuable for banks that need to staff up to deal with additional demands [from regulators].”
Victoria Averbukh, director and senior lecturer at Cornell’s financial engineering department in Manhattan, says more of her students are considering working in risk management.
“The financial industry comes back for financial engineers where they need to solve their risk management problems and they need to analyse the data,” she says. “There was a backlash against engineering . . . Now it’s moving on.”