How teaching finance in MBA curriculum should change post crisis?

JR Varma of IIM Ahmedabad has written a nice paper on the topic. As one of the leading professors of finance in India, it is useful to hear his views on teaching finance post the crisis. (Read this speech as well from a Canadian Finance professor)

Summary of Prof Varma’s paper is finance theory needs to change with times. It needs new insights within finance and also take ideas from other fields like sociology, psychology etc. Moreover, we need more maths and models :

Finance has come in for a great deal of criticism after the global financial crisis of 2007 and 2008. Clearly there were serious problems with finance as it was practiced in the years before the crisis. To the extent that this was only a gap between theory and practice, there is a need for finance practice to go back to its theoretical roots. But there is a need to re-examine finance theory itself.

The paper begins with an analysis of what the crisis taught us about preferences, probabilities and prices, and then goes on to discuss the implications for the models that are used in modern finance.

The paper concludes that the finance curriculum in a typical MBA programme has not kept pace with the developments in finance theories in the last decade or more. While a lot needs to change in finance teaching, finance theory also needs to change though to a lesser extent. Many ideas that are well understood within certain subfields in finance need to be better assimilated into mainstream models. For example, many concepts in market microstructure must become part of the core toolkit of finance. The paper also argues that finance theory needs to integrate insights from sociology, evolutionary biology, neurosciences, financial history and the multidisciplinary field of network theory. Above all, finance needs more sophisticated mathematical models and statistical tools.

Interesting paper. Prof Varma covers many ideas in a very short space.

The discussion on market microstructure and its importance is very interesting. Price is central to economics and but what is the price in financial markets – bid price or ask price? or weighted average price?

In discussions about price in market microstructure, the term price must be qualified to make clear what we are talking about. There is a bid price, there is an ask price, there is a mid price, there is a last traded price, and there is a volume weighted average price, but there is no such thing as “the price.”

The most important prices in market microstructure are bid and ask prices which represent the prices at which one can sell and buy respectively. However, these are valid for relatively small quantities. For any person contemplating a medium size transaction, it is necessary to examine the entire order book to determine the price at which the transaction can be completed. For larger transactions, it is necessary to make an assessment of latent orders – bid and ask orders that are not currently in the order book – to determine the potential transaction price.

In sum, prices are volatile and change all the time:

At microstructure level, sharp and rapid price declines (market meltdowns) and the converse (meltups) happen all the time. For example, any sell order large enough to sweep through the whole or a major fraction of the bid side of the order book would cause a steep decline in prices within seconds (if not milliseconds). It might take several minutes for enough latent orders to enter the order book and reverse this meltdown. Conversely, a large buy order can send the price shooting upwards in the space of a few seconds or even milliseconds.

Tail events are more common in microstructure theories. Infact crisis are nothing but market microstructure writ large. In macroeconomics we assume financial noise is aggregated and cancelled. This is just not true:

At the microstructure time scale, these “tail events” cause price movements that are several times the range that would be expected from a Gaussian* distribution. Microstructure theorists would not regard these markets as dysfunctional or irrational. On the contrary, what is important in this context is the self correcting ability of the market that restores equilibrium over the space of several minutes or hours. Taking into account the various frictions (search and information costs, transaction costs, and leverage restrictions), we should probably consider a market which experiences such microstructure meltdowns or meltups to be an efficient market.

These considerations lead us to consider the possibility that a financial crisis is simply market microstructure writ large. At the macro level, we tend to assume that “microstructure noise” has been washed out. It is then tempting to think of the market as being in continuous state of equilibrium rather than in a perpetual state of movement towards an ever changing equilibrium. Perhaps, this is a mistake and the complexities of the microstructure world are present at longer time scales as well. This would of course imply that markets are messier and more complex than the ideal friction free market.

From a different perspective, however, the hypothesis that financial crisis is simply market microstructure writ large is very attractive. It means that we have the theoretical tools and techniques (of microstructure theory) to study crises. At any rate, I think that all finance researchers must not only learn market microstructure theories, but also take them seriously as potential explanations for even macro scale phenomena.

What about the famed EMH? Prof Varma has a nice take on this as well:

We must distinguish between two important aspects of the efficient markets hypothesis (EMH) because the global financial crisis has led to diametrically opposite conclusions regarding these two perspectives:

· The first perspective is summarized by the statement that there is no free lunch or that it is not possible to beat the market in risk adjusted terms. If something is too good to be true, it is probably not true. The global financial crisis has strengthened this claim. All those apparently low risk, high return investments turned out to be high risk.
· The second perspective is that prices are “right” in the sense that they reflect fundamentals. The global financial crisis has weakened this claim. Many prices were clearly not right.

The EMH does not justify a light touch regulation of too big to fail banks. On the contrary, the no free lunch form of the EMH ought to lead regulators to suspect that an incredibly profitable bank is an incredibly risky bank and therefore needs high levels of capital to mitigate the risk. Thanks to the Modigliani-Miller theorem, much higher capital requirements on the banks have low economic cost.  Finance courses need to teach more about the limits to arbitrage not just in terms of behavioural finance, but in terms of well specified market micro structure with proper attention paid to transaction costs, leverage, and collateral requirements. The important stream of literature linking funding liquidity and market liquidity needs to be part of the core courses in financial markets.

It is actually amazing how EMH has been interpreted by doyens of finance. Fama the founder of EMH said in this interview the second perspective of EMH – prices are right – stood the test of the crisis. His idea is that the crisis is a result of the fact that prices were not in line with fundamentals. And hence the correction in form of crisis.

I asked Fama how he thought the theory, which says prices of financial assets accurately reflect all of the available information about economic fundamentals, had fared.

Eugene Fama: I think it did quite well in this episode. Stock prices typically decline prior to and in a state of recession. This was a particularly severe recession. Prices started to decline in advance of when people recognized that it was a recession and then continued to decline. There was nothing unusual about that. That was exactly what you would expect if markets were efficient.

The founder himself has a different take on what EMH means..

Another superb advice is to look at both fin markets and institutions:
Over the years, finance teaching (and to some extent finance theory) has come to be segmented between Financial Institutions and Financial Markets. This segmentation is increasingly untenable as the dividing line between institutions and markets gets blurred.
The repo market is a good example of this blurring of lines. Pre crisis, courses on fixed income markets placed a lot of emphasis on the repo market as a critical component of the bond market. But neither the markets courses nor the banking courses looked at the repo market as being akin to a bank or a financial institution. After the crisis, Gorton and Metrick (2009) have taught us that the repo market is a “shadow bank” vulnerable to old fashioned “bank runs” (see also Pozsar et al, 2010).
He says financial econometrics should be grounded in history which is welcome as well.
Very useful primer on finance teaching  from Prof Varma.
However, going by the huge list of changes one wonders how would all this be included? It could be better justified in PhD in finance. But still one needs to make MBA finance more realistic as well. A challenge for finance professors for sure.
Another aspect which is needed for humility. Most finance professors portray themselves as superstars with know it all/ done it all attitude. Finance is taught as a black and white theory whereas much of it is grey. Students need to understand the limitations of the subject and pitfalls of blindly believing that finance is virtuous.  There is also a need to explain to students the job-roles in finance. Most students are blinded into taking finance looking at huge salaries without knowing anything about the roles. The most common of such fallacy is wanting to become an investment banker. None of the global i-banks are there anymore but still the craze/fallacy has not really died. The salaries also remain as high as ever which keeps pushing students into taking finance as a career choice.
Some bit of humility and reality check from the curriculum will also happen.

2 Responses to “How teaching finance in MBA curriculum should change post crisis?”

  1. Was CFA enrollment affected in the global crisis? « Mostly Economics Says:

    […] from the crisis for CFA is to have more of macroeconomics and lots of ethics as well. Prof JRV has suggested some changes in the finance curriculum as well which could be seen as […]

  2. business administration finance degree Says:

    finance online degrees…

    How teaching finance in MBA curriculum should change post crisis? « Mostly Economics…

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