Finance : the new paradigm

In his latest book, Philippe Herlin, in light of the crisis and following the work of Mandelbrot and Taleb, presents the agenda the question of the reliability of the classical models used in finance.

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The powerful financial cataclysm that shook the markets and caused the collapse of investment bank Lehman Brothers in the fall of 2008 was not only indicative of the danger of the increasing complexity of financial products, but also symptomatic of the fragility of the intellectual edifice on which was built until now the financial theory.

In his latest book, Finance: le nouveau paradigme (Finance: the new paradigm), Philippe Herlin, in light of the crisis of 2008 and following the work of Benoit Mandelbrot and Nassim Taleb, presents the agenda the question of the reliability of conventional models used in finance and economics and the base of reference that practitioners still use to develop them.. The seven chapters of this book, a real indictment against the "orthodox theory" are essentially questioning the Gaussian universe as a framework for the only probability distribution currently used in finance, the normal distribution..

After explaining in the first part of the book the genesis of what he calls the "classical model" - Bachelier’s theory of speculation, Fama ’s market efficiency, Markowitz and the portfolio theory, CAPM and the Sharpe ratio, Black-Scholes option pricing model - and put into perspective the emergence of these ideas in the historical context which has made them sustainable (including the development of the computer industry to promote financial engineering of the current 1970s and the return of growth, lower inflation and financial deregulation in the 1980s), Herlin addresses the second part of his book by asking this important question that will serve as guiding principle of the whole book: "the cataclysm of September 15, 2008: a bug in the model?".

While the previous financial crises stemmed from a disruption of economic fundamentals (1997-1998 Asian crisis, internet bubble in 2000), the 2008 crisis we are experiencing today according to Herlin is still partly , "a crisis of language of finance, its concepts, its methods, including the calculation of risk". Based on the work of Mandelbrot questioning the Gaussian curve and the neoclassical assumptions that underlie it (continuity and independence of price changes, rational agents, etc..), Philippe Herlin will discuss the mathematical origin of the 2008 subprime crisis and highlights the failure of the Gaussian copula used to calculate the default risk of multiple debtors.

The decor being set, he then accurately comes back in an educational on the work of Benoit Mandelbrot and provides a comparative resume of the fractal model with its famous power law and the normal distribution as part of their application to stock prices. The finding for him after this is so clear: "the normal distribution applies to a particular area where there is a fundamental value, that is to say a truth rationally knowable. [But] there is no fundamental value [in the case of financial markets]. Conclusion: We head to a power law "

Continuing in the direction of this argument against financial orthodoxy, the book then abandons the field of stock prices to plunge into business finance. And Philippe Herlin will undertake to demonstrate that even in this field, the last bulwark between markets and the real economy, the deep involvement of businesses into financial theory (using the CAPM and the Black-Scholes model, among others) and the Gaussian assumption of its models has led to an underestimation of a number of risks and thus make decisions that can be dangerous for business. One consequence is that he said that "the measure of the company performance [was] moved from sales to capital used. It is no longer the margin on sales that counts but the return on capital invested. " For Herlin, all this movement shows finally that "the transition from entrepreneurial capitalism to shareholder capitalism, or financial, that is to say a capitalism in which the industrial logic is backing against the pursuit of profitability without relation to economic reality, to the sole benefit of the capital holders . "

In the last part of the book, Philippe Herlin will highlight what might be considered the framework of financial theory in the future he called "fractal finance" and "fractal company".

After reporting on the prospects that this approach (initiated by Mandelbrot and Taleb) may present as part of risk management and for the financial industry in general, he will conclude his work by the common sense of observation that summarizes the most of its two hundred pages of indictment: "The myopia of markets is that of Gaussian glasses. We must defend entrepreneurial capitalism because it sees far better and take better into account exceptional phenomena, given a financial capitalism reasoning with the blinders of the Gaussian curve. Recognition of the presence of power laws in the economy could even reconcile them both and to better communicate the corporate world and that of finance". May he be heard.

Yann Olivier August 2010

Article also available in : English EN | français FR

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