"Doctoral training provides you with knowledge and a set of tools which can be used in the industry. For example, we all read about the complex derivative products at the heart of the current financial crisis—it is useful for professionals in the finance industry to understand what models were used to price and manage these products and what went wrong"
Why did you decide to join EDHEC’s PhD in Finance as a member of the affiliate programme faculty?
First of all, the programme is very well designed and has a potential for a rapid increase in visibility and appeal to high quality students. I was attracted to its mix of theoretical and practical aspects and expected that the experience of teaching in the programme would be both useful and pleasant for me. I taught a course on options in the MSc in Risk and Asset Management at EDHEC Business School in 2007, and I was impressed by the quality and focus of the students. In addition, Nice, with its climate, food and hospitality, is a beautiful city to spend some time in.
Last but not least, I have written papers with Professor Lionel Martellini and was looking forward to working on new projects with him.
Continuous time finance (CTF) was initiated by a graduate student from Caltech, Robert Merton, in 1969. What are the main results from the research in the field over the past forty years that every professional should keep in mind during his daily work?
The main insight from the research of Robert Merton, Fischer Black and Myron Scholes is that, under ideal conditions, one can trade in options and underlying basic securities so that all the risk is eliminated.
Put differently, if the assets are not priced correctly relative to each other, there is a possibility for high profits, or, for those on the other side of the deal, unnecessary losses. As the years progressed, it was shown that more sophisticated models can improve correct pricing. However, it was also shown that when the conditions are not ideal, there is no single correct price for a derivative, the large bid-ask spreads can be consistent with the theory, and pricing will depend on risk preferences.
In the last two decades great machinery for measuring market risk has been developed, and the professionals should be aware of its usefulness, but also of its limitations, as evidenced in a striking way by recent events.
On another front, CTF has shown how a single investor should trade in order to maximise her expected utility from profits/losses. What has not been done much—but I believe that CTF can play a role in this regard—is to analyse what can happen in situations in which interaction of many market players can move prices and cause bubbles, crashes, as well as market booms and crises. In other words, I think it is possible to use CTF not only from the point of view of the benefit of a seller/ buyer, but of the whole market, or, if you prefer, from the point of view of a regulator.
You have just delivered the first part of the “Continuous Time Finance” course to the inaugural class of the EDHEC PhD in Finance – what are your impressions?
The students are all very alert and enthusiastic… even after spending the morning in the Empirical Finance class, they still bring a lot of energy to the CTF class. They also seem to be smart and hard-working. Since they come from very different backgrounds, I emphasise the intuition in class to let them work at their own pace on the proofs at home. They seem to be doing just fine and it is a very pleasant experience for me.
Is teaching experienced professionals any different from teaching traditional PhD students?
These practitioners bring a very fresh perspective on the material—they want to apply tools to practical problems whereas traditional PhD students are typically more interested in the theory. I am also able to cover the material more quickly since I can skip product descriptions—as experienced professionals, they know about options or credit derivatives—and go directly to the models.
What is the use of a PhD in Finance to an executive?
Well, I asked the class yesterday. An answer I got pointed to a desire to be better at one’s job. Doctoral training provides you with knowledge and a set of tools which can be used in the industry. For example, we all read about the complex derivative products at the heart of the current financial crisis—it is useful for professionals in the finance industry to understand what models were used to price and manage these products and what went wrong. Naturally, there’s always the risk for a professional who invests in a PhD to get caught up in research and be seduced by the sirens of academe.
What are your own research themes at the moment and could you tell us a bit about your findings?
In recent years I have been trying, together with a number of other researchers, to develop a continuous-time theory of optimal contracts. In other words, to find ways of compensating managers and executives so that both the firm and the manager have their objectives satisfied.
What we have found is how the optimal shape of compensation depends on the risk preferences of the firm and the manager, how it depends on the information they have access to, and on whether the manager can hedge or not. In particular, we show under which conditions it is better to compensate primarily with cash, or shares, or options, or relative to a benchmark, or something else. I have been working on a book on this topic, together with my co-author Jianfeng Zhang. I discussed this book’s salient results at the EDHEC research seminar.
Another project involves an analysis of the optimal entry into a joint venture by two firms, and the optimal profit sharing between them.
On a different front, I am involved in projects that consider the problem of the optimal hedging behaviour for firms which have pension or other permanent liabilities, and how to value the equity and debt of such firms.
Finally, I have started some new projects related to the effect of multi-agent interaction on the prices of assets, as well as their volatility. The hope is that we will be able to understand better how bull and bear markets are formed, and what can be done to prevent damaging market events. In the same vein, and just weeks ago, I started looking at price formation when there are many traders with different information sets: what is the effect on price when information is correlated and traders can learn from one another by observing trades on the market.
With the hindsight of experience, what is your advice to PhD candidates?
My advice is to focus on what you are really excited about using the skills that constitute your competitive advantage; there are many ways to approach the same topic depending upon your taste and skills. At least that worked for me.