How to gain a deep understanding of decentralised finance
Professor Raman Uppal teaches decentralised finance to MSc in Financial Engineering students. His research focuses on optimal portfolio selection and asset allocation in dynamic environments, the valuation of securities in capital markets, risk management, and exchange rates. Prof. Uppal tells us about decentralised finance and his approach to teaching.
What can you tell us about your field of research?
My research focuses on three questions: How do households make investment decisions? How should we make investment decisions? How do our investment decisions impact financial markets and the macroeconomy?
In answering the first question on how households invest, I show that most individual investors (as opposed to institutional investors) make very poor investment decisions. For example, rather than diversifying their investment across a large number of assets, which is easy to do using investment vehicles such as exchange-traded funds (ETFs), they invest in, on average, just two or three assets. Moreover, these assets are often in companies where they work or companies that are located close to where they live. As a result, their investments are very poorly diversified.
On the second question, I show that many of the models suggested in the academic literature do not work very well in the real world. In particular, the models in the academic literature often ignore estimation error (that is, decisions made on the basis of past data may not work very well in future) and transaction costs. As a second step, I develop models that work well “out of sample” (that is, models whose performance is not sensitive to data in the past) and in the presence of transaction costs.
Where the third question is concerned, I study the impact on the entire economy when individuals change how they invest. For instance, I show that if each individual invests in a portfolio that is better diversified than a portfolio with investments in only two or three assets, then, not only is the individual better off, but it also improves the growth and welfare of the entire economy.
How important is the use of academic research in your course?
Academic research is fundamental to all of the courses that I teach. That is, instead of teaching what is commonly believed to be true, what I teach is based on actual evidence. So, most of my course content is based on recent academic literature.
You have received many awards for your teaching, one of them the EDHEC prize for pedagogical excellence. What is your teaching philosophy?
My teaching philosophy is to provide students with a deep understanding of the fundamentals of financial economics. Almost all of the material I teach is based on research insights into finance that have received Nobel prizes. Another point of my teaching philosophy is to provide an integrated, coherent view of finance rather than teach a series of topics that are disjointed. For example, a large part of finance follows from the Law of One Price, which states that two assets with the same cashflows must have the same price. In plain language, the cost of buying two apples and three bananas individually must be the same as buying a bundle or basket containing two apples and three bananas. This is an extremely simple insight, but many of the key insights in finance follow from this simple logic.
What is decentralised finance? What are its benefits and risks compared with traditional finance?
Decentralised finance, as the name suggests, is finance where instead of having a centralised institution, transactions are managed in a decentralised manner, usually using blockchain.
Decentralised finance challenges existing centralised financial systems by replacing traditional banks, brokerages and credit-card companies with an alternative digital system that allows peer-to-peer transactions. As a result, decentralised finance reduces transaction costs and broadens access to financial services to more people.
On the negative side, decentralised finance, because it is largely unregulated, suffers from the risk of fraud. The recent news about FTX highlights some of the things that can go wrong in the absence of regulation.
What are the main concepts the students will encounter on this course?
The objective of this course is to understand decentralised finance and the blockchain technology driving this revolution. The course will focus on studying the benefits and limitations of blockchain technology compared with traditional centralised finance. We will examine how blockchain technology can be used to develop new ways of doing all the functions of finance: new payment methods, new methods for financing ‒ via debt and equity ‒ and new methods of investing. Some of the topics covered will be cryptocurrencies, smart contracts, oracles and stable coins.
Are there books or publications that students should read in preparation for your course?
Yes, there are a large number of books on decentralised finance that one can read to prepare for the course. I would recommend reading Defi and the future of finance by C.R. Harvey, A. Ramachandran and J. Santoro. (2021, John Wily & Sons). For a more entertaining, but less academic book, students can read about the start of Coinbase, as described in Kings of Crypto: One Startup's Quest to Take Cryptocurrency Out of Silicon Valley and Onto Wall Street by J.J. Roberts (2020).
What do you expect your students to learn and have mastered on completion of your courses? What skills do they gain?
I expect students to have a deep understanding of decentralised finance. In particular, I expect them to understand how blockchain technology works, its advantages, and its limitations. I expect them to understand the benefits and risks of cryptocurrencies. They should also acquire an understanding of how to design new payment systems, new methods for raising capital, and new methods for investing. My hope is that by the end of the course, each student has sufficient knowledge about decentralised finance to get a job in that sector.
For more information on Prof. Uppal’s research papers:
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