Investment Banks and Mathematical Modeling

September 15, 1998

Joseph Langsam

How does the finance industry interact with the academic community? From the perspective of the university community, the most desirable way would be for an investment bank to contract with a university to solve an important problem in mathematical finance. Such an arrangement hasn't occurred and isn't likely to occur in the future. There are, I believe, two fundamental obstacles to the development of consulting relationships of this type.

First, many of the more interesting and pressing problems are associated with proprietary trading. The banks want to protect any real or perceived proprietary edge they have, and there is a perception that a consultant might "shop" solutions. Second, our problems have a level of complexity that makes them inappropriate for presentation to an outside consulting agent. Because many banks have made heavy investments in technology and research infrastructure, any solution to a new problem will be best developed as an extension of the existing models. Any consultant faces a steep learning curve, one that the investment banks are loath to finance.

Does this mean that there will be no interaction between the academic and industrial communities? Quite to the contrary, the two communities currently interact in numerous ways. Despite my earlier comments, the industrial community does utilize academic consultants. For the reasons I mentioned, however, the industrial community tends to restrict the consulting relationship to the top few professors in the academic community. Widespread financial support for consulting is unlikely.

Consulting, however, is but one of several ways in which the two communities interact. The industrial community is one of the biggest purchasers of the educational product produced by the academic community. Simply stated, we employ the students the academic community educates. Several of us in the industrial community serve on academic boards to assist the universities in designing their undergraduate and graduate finance and mathematical finance programs. The careers (and high salaries) in the finance industry have contributed to the success of master's programs in financial engineering and financial mathematics. Mathematics departments at several universities have been able to use such programs as a source of revenue. In addition to hiring former students, the banks are also sources of employment for faculty members who wish to leave academia or who wish to gain practical experience and then return to the university.

There are several other, perhaps more subtle, mechanisms of interaction. The numerous analytical research groups on both the buy and the sell sides of the financial industry, for example, are voracious users of the academic research available in journals and preprints. The academic literature frequently ignores salient features of the market environment, such as day count conventions, regulatory capital requirements, tax treatment, and odd lost cost supplements. Nevertheless the academic literature provides key insights that motivate the applied research and application development.

In addition, many practitioners on "Wall Street" are former academics who have maintained their ties with the academic community. Several of these ex-academics are active in university seminar series, and a few retain teaching responsibilities. The research groups on Wall Street are insatiable consumers of financial research, particularly as it relates to modeling derivatives and risk management issues. Several practitioners in Wall Street research groups are reviewers for leading financial journals, and some continue to contribute to these journals.

Taking advantage of a relatively new program of the National Science Foundation, Morgan Stanley Dean Witter is now cooperating with the Department of Mathematics at Columbia University to oversee one of NSF's Industrial Postdoctoral grants. Under this grant, the postdoctoral fellow, a recent PhD graduate in mathematics, spends several days each week at Columbia and the remainder at the bank. Problems related to the bank's modeling of derivatives are included in the postdoctoral fellow's research program. The research is expected to reflect academic standards; the expectation is that sufficient components of the research will be nonproprietary and publishable in an academic journal.

The prospect for even greater academic-industrial interaction is encouraging. The growth in cooperative research continues to be stimulated as the academic community recognizes the market environment in which the banks operate and as the industrial community recognizes the value of the expertise residing in academia. Senior banking managers who once looked on sophisticated mathematical finance research as esoteric and unrelated to the business world now regard mathematical modeling as central to the risk management of the bank.

Looking ahead, I anticipate that the academic community will welcome the banking community's contributions to the development of curriculum and to the identification of critical research topics. I expect that the banking community will turn to the academic community to develop training programs for both new and experienced banking professionals. The potential for interaction remains greatest in the further development of academic-industrial conferences and seminars where ideas and needs are exchanged. Further employment and consulting relationships will then be developed from these activities.

Joseph Langsam is a managing director at Morgan Stanley Dean Witter, where he is responsible for analytic research for the Fixed Income Division. Langsam received a PhD in mathematics from the University of Michigan and a PhD in urban studies and economics from the Massachusetts Institute of Technology. Prior to joining Morgan Stanley Dean Witter in 1985, he was an assistant professor of mathematics at Case Western Reserve University.


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