The specter of the Covid-19 crisis was never far off during the Center for International Securities and Derivatives Markets' (CISDM) annual conference on October 2. The keynote speaker examined the role of asset pricing in model building for societal challenges (illustrated by the crisis of carbon capture). And the conference’s second headline presentation dissected the shortcomings of U.S. Treasury Bonds as a safe haven during the onset of the pandemic crisis last March. The conference, moreover, was virtual—both for its five presenters and its prominent national audience.
As in previous years, the event addressed the intersection of finance, economics, and public policy. Previous CISDM conferences have featured policy lessons from the 2008 financial crisis, climate change, digitally enabled financial innovation, and social entrepreneurship. Arguably the planet’s leading academic research center for derivatives and alternative investments, Isenberg’s CISDM views its mandate broadly, encompassing technical financial research and public policy issues. This year’s conference, like its predecessors, made good on those aims.
Asset pricing and social impacts
Methods of asset evaluation have applications beyond their traditional market roles. They can help us to evaluate social activity, including the social cost and impact of climate change, observed keynoter and University of Chicago economist Lars Hansen (pictured above, and presenting at right) at this year’s annual CISDM conference. Hansen is David Rockefeller Distinguished Service Professor in Economics and Statistics at the University of Chicago’s Booth School of Management. In 2013, Professor Hansen shared the Nobel Prize in Economics for his contributions to the empirical analysis of asset prices.
In his lecture to CISDM’s large virtual audience, Hansen explored “asset type methods” for evaluating societal costs of excessive carbon emissions. The latter, he observed, alter climate, which in turn influences economic opportunities and social well-being. You can view that externality as a social “tax” on carbon, he said. The tools of asset pricing, then—combined with those from decision theory—can help us gain a better handle on carbon-driven costs.
Hansen devoted much of his lecture to challenges posed by uncertainty in model building itself. Uncertainty within (risk), across (ambiguity), and about (misspecification) models can all emerge. He recommended employing less than optimal models sensibly rather than discarding them. Tools from probability and statistics can help limit the type and degree of uncertainty at hand. And model builders need to address their dislike of uncertainty accompanying probabilities of future events.
Addressing those considerations is critical given that alternative scenarios accompanying carbon emissions, their social/economic costs, and policy decisions themselves pose uncertain outcomes. When those uncertainties interact, outcomes can prove multiplicative—especially when decision makers are averse to model ambiguity and misspecification. Yet another consideration, he added, is nonlinear jumps in climate change—e.g., rapid changes in temperature and permafrost—which are tricky to anticipate. We must build richer models, he emphasized, to combat climate change, including greater reliance on renewable energy and nature-based solutions.
Treasury bonds prove unpredictable
U.S Treasury bonds were supposedly a safe haven, but their performance in March following the onset of the pandemic offered another story, observed the conference’s Distinguished Speaker, Darrell Duffie (pictured right). In previous economic crises, including the 2008 recession, yields on Treasury bonds plummeted as demand soared. In mid-March, however, volatility ruled the day with yields bouncing up and down. Bond markets choked on demand forcing the Fed, the European Central Bank, and the Bank of England to buy up U.S. Treasury notes to right the ship. The yo-yo effect revealed an ineffective market structure, underscored Duffie, the Adams Distinguished Professor of Management and Professor of Finance at the Stanford Graduate School of Business.
A two-tier bond market where “you must use a dealer to trade” was mostly to blame, Duffie continued. Dealers, he noted, transact for big banks and can trade with each other, but the banks must use those large dealers as intermediaries. With the size of marketable treasuries on big-banks’ balance sheets skyrocketing, dealers became overwhelmed in a wash of cheap debt financing. (Projected trends tell the same story.) That is unsustainable, said Duffie—jet fuel for a “too-big-to-fail” predicament among the banks.
“The crisis taught us a tough lesson about market structure,” he observed. Ensuring market stability above all cries out for broad central clearing, he emphasized. That would provide a system-wide mechanism for updating accounts of trading parties and arranging for bond and cash transfers, which all participants would be required to report. In addition to improving efficiency, clearing would further financial stability by freeing up dealer balance sheets. And it would allow for the possibility of “all-to-all” trading, where the banks could trade directly with one another. The U.S. equities market, Duffie said, employs clearing. In March, it “did not become dysfunctional.”
Three additional speakers presented at the conference. Sanjay Nawalkha, a professor of finance at Isenberg, introduced a new theory of equivalent expectation measures for deriving analytical solutions for expected prices—current and future—of contingent claims. Jens Jackwerth, a professor of finance at the University of Konstanz, discussed limitations of the well-known Ross Recovery Theorem in predicting realized returns and variances in state-price securities. And Peter Carr, a professor of economics at New York University’s Tandon School of Engineering, examined the history behind the development of the famous Black-Scholes-Merton model. He pointed out that a 1970 unpublished paper by Merton anticipated many of the subsequent trends in derivatives pricing—a topic fundamental to CISDM’s mission.