Intellectual Harness of the Financial Markets

This article contends that Finance has a tendency to harness the market with intellectual models which do not always represent the underlying dynamics of the market. In sociological terms, a cohort of mathematically literate financiers regularly attempts to create models with a view that they will become self-fulfilling. Their intention is to influence the market so that it behaves within the parameters of the model. An example was shown by MacKenzie,D. & Millo Y (2003) as they describe how the Black-Scholes formula has had a large influence on the option market. Financial engineers are bound to have some influence on the market; for example, sophisticated pricing models ensure that there are not arbitrage opportunities. But their influence can largely overreach this remit.

This article proposes to explore how financial models evolve with the markets. We will first look at a straightforward evolution describing how the derivative valuation paradigm has changed historically in the context of interest rates modelling. Like its homologue process in numerical modelling in science, financial valuation techniques evolve when they encounter inconsistencies between the theory and practical observations. In particular, pricing techniques for interest rates have reacted strongly to the Great Recession. We will see that these pricing methodology changes managed to come together and ended up influencing the reality it was intending to model. In other words, this particular piece of the financial pricing tool ended up performing the market.

In a second part, we will explore an equity-credit model which was an attempt to link the equity option market with the credit market. Although the approach was rooted in an intellectually robust model, this particular method ended up not influencing the market. We will finish by asking the following question : what drives the acceptance by the market of a particular pricing method ?