The Hindu Business Line : Quants improve understanding and risk management

It was bound to happen sooner or later. After Keynes, economics was already profusely applying advanced math and statistics, to the point where complex models, purporting to describe the functioning of economies, have become common.

With not much success, though. The forecasting record of the best of models has been poor. However, this does not mean they are useless. Their strength lies at least in describing and understanding the interrelationships between sectors. It was said of Mr Alan Greenspan, former Chairman of the US Federal Reserve, that he could quantify the impact of General Motors consuming one more or less bolt on the economy as a whole.

It is in predicting turning points that models have failed. When exactly will serial cuts in interest rates revive a flagging economy? Or how many interest rate rises will it take to reduce inflation to levels that a government and central bank are comfortable with? There is not even approximation here, let alone exactitude.

For example, the US has been seeing an inverted yield curve (i.e., short-term bond yields were more than long) for almost last year. It is usually considered the harbinger of a recession (defined as two successive quarters of negative growth), but the economy is far from one. And the wakeup call was as sudden as it was unexpected. In a matter of days last week, the yield curve corrected. The economy (so far at any rate) is showing little indication of slipping into negative territory.

Actually, the inverted yield curve was buttressed by the negative readings on leading economic indicators - current data, which, based on past analysis, were found to be good predictors of the future. But many economists thought (rightly so, it now seems) things could be different this time.

The massive buying binge in Treasuries by Asian central banks saddled with huge dollar reserves proved to be more than effective in dragging bond yields lower even as the Fed engaged in raising rates, meeting after meeting. Thus, the inversion of the yield curve lost its usual significance.

The results of quantitative finance are better. The management of risk, in particular, has grown increasingly sophisticated as well as effective.

Collapses of financial institutions there have been, but it has (fortunately) not lead to systemic danger. The last time a central bank-initiated bailout was necessary was almost a decade ago, in 1998, when Long-term Capital Management (LTCM), with Nobel laureates at the helm of affairs, failed.

On balance, models enhance our understanding of economies, markets and risk. They have more than fulfilled their purpose.

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