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Often times, finance and physics are considered as mutually exclusive fields, with little or no
correlation whatsoever. However, if you take a closer look, you can see the glaring similarities between them. For each of these, I will try to touch on some of the material issues that have generated significant interest in each field.Financial crises
The world of finance is not short of overwhelming events that go beyond our wildest expectations, and catch even the best analysts off-guard. From the most recent financial crisis of 2008, to the fifteen-minute flash crash of 2010, to the most recent short-squeeze of video-game company Game Stop; the financial markets have proven that they cannot be mastered.
In my opinion, there is mainly one cause of uncertainty in the markets: the markets are fundamentally based on human behaviour and psychology, which is largely unpredictable, and cannot be sufficiently modelled.
Traditional finance is based on the assumption that all market participants are rational. However, the reverse is true. In many cases, people are driven more by psychological biases, than common sense itself. This has led to studies that combine neuro-biology with finance and economics – “neuro-economics”. It focuses on how the human brain generates chemicals that influence decision-making, and hence is a constraint to fundamental economic theory.
Leading up to the 2008 financial crisis, banks were doing risk assessments that seemed sufficient at the time, had collateral that seemed sufficient, and were very optimistic about the future.
However, we were all living in a bubble, which was about to burst, but very few analysts could actually tell.
In hindsight, we realize that banks were not making enough provisions on bad debts, stress tests were not exhaustive enough, investment banks were converting low quality mortgages into high-quality bonds, and selling them to pension funds, etc.
Of course, at the time, these bonds seemed to be of high quality, since they were issued by government-backed agencies like Fannie Mae, and had significant collateral. However, these bonds’ high credit rating was all based on an incorrect assumption: property value can only increase, and besides, if any client defaulted, they could recover their money plus an abnormal profit. In addition, these were government-backed issuers, which could not default.
However, their models could not simulate all possibilities that could evolve from human behavior, to model them into risk & return scenarios. This was because these risks and returns were so intertwined like a cobweb throughout the entire industry.
Commercial banks sold relatively high-yield mortgages to Fannie Mae, and simultaneously invested in Fannie Mae bonds, which were secured by similar mortgages. These same bonds were securitised by an investment bank, and given a high credit rating by a credit rating agency – which also invested in the same bonds. In addition, these bonds were insured by insurance companies through credit default swaps. Effectively, this enabled the biggest funds, which generally have a low risk appetite, to take a significant share of the high yields from mortgages, without having exposure to the default risk of these mortgages.
The relationship became so lucrative to the big funds, since they were receiving yields much higher than normal. However, their available capital outweighed by far, the eligible mortgage applicants, and yet their thirst for yield could not be quenched.
At the source of this relationship was the mortgage borrower. At this point, it was clear that the solution was to significantly increase mortgages – even to applicants who were not eligible, in order to feed the entire chain.
Therefore, when mortgage borrowers started defaulting and the property values dropped, the entire chain of stakeholders were significantly affected, and the financial crisis started to unravel like a burning bush.
As the legendary boxer Mike Tyson put it, “Everybody has a plan until they get punched in the mouth."
Quantum mechanics
The world of physics is largely predictable and makes perfect sense, until you get to the micro-level of atoms. Quantum mechanics is the study of how atoms behave, and hence it explains how chemistry, biology and physics work. Put simply, it is the explanation to how everything in the universe operates.
Even some of the most mind-boggling discoveries like black-holes, the big bang theory, time-space continuum; are child’s-play, when compared to how atoms operate.
At the level of atoms, the famous laws of physics no longer apply; things seem to operate on an almost-mystical or spiritual logic.
Albert Einstein died before he could figure out why things happen the way they do at that level – “the theory of everything” as it is called. A few scientists thereafter tried to decode this theory, but with no success.
Therefore, both financial crises and quantum mechanics cannot be modelled. Nonetheless, an attempt may be made at the former, rather than the latter. In addition, the fundamental causes of both mysteries (financial crises and quantum mechanics) lie within the human being – the human brain, and atoms.
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