Investors have long searched for the financial equivalent of the Holy Grail - the magic formula that can forecast movements in financial markets. Now physicists under the umbrella of a pioneering new branch of science, econophysics, are attempting to find it. This fast growing field has already unveiled new ways of forecasting market crashes and introduced better measures of financial risk for increasingly volatile markets.
Econophysics draws on the understanding of natural occurring phenomena such as earthquakes, turbulence and the behaviour of atoms to explain fluctuations in asset prices. Eugene Stanley, professor of physics at Boston University who coined the term six years ago, says the controversial field approaches the study of economics from a scientific basis. "Economists usually start with a theoretical model and then later test the model against real data. Physicists start with the study of empirical facts," he said. Inconsistencies between economic theory and reality provide the rationale for such an approach. Jean-Philippe Bouchaud, a managing director of Capital Fund Management (CFM) in Paris says the problem lies in how economic theories are constructed: "Simplistic assumptions are devised to make economic models simple and tractable. Empirical evidence should supersede any theoretical concept."
Econophysicists begin by viewing financial markets as complex evolving systems whose fluctuations result from the collective behaviour of thousands of investors, traders and speculators who buy and sell assets in pursuit of profit. Using computer simulation models, similar to those employed in physics to analyse the interactions between molecules, physicists are trying to model the effects of different trading strategies on the overall market. In particular they seek to find simple trading rules that could generate large market movements such as Black Monday in October 1987 when the FTSE 100, Britain's benchmark stock index, lost 22 percent within two days.
Crashes and bubbles, say econophysicists, represent "phase transitions" which occur in physics when individual atoms behave in a collective way resulting in a transition from one state to another such as water turning into ice. "Investors sometimes seem to do things collectively and co-operate in a way that can lead to
crashes," said Bouchaud. Some econophysicists even claim that the financial equivalent of phase transitions, crashes, can be predicted. Didier Sornette, professor of geophysics at the University of California, has published papers showing an acceleration in the frequency of price fluctuations before such events. His model predicted the timing of the rise in the Japanese Nikkei Index in 1999 which rose by 41 percent in the year.
Although the jury is still out
on whether such models can reliably predict when crashes will occur, Professor Stanley says econophysics has quantified the probability of market movements both large and small based on a law that governs earthquakes. Of course the application of scientific tools to economics is nothing new. Economists have analysed data for decades using econometrics - predictive statistical techniques that quantify relationships in economic and financial data. Bouchaud says however, there is a difference between econometrics and econophysics in terms of the level of mathematical rigour: "Many discoveries of econophysics are rediscoveries, but some of the effects have been better quantified." One such area is measuring market risk.
Physicists have found that the probability of large market fluctuations is greater than pure chance would predict. Failure to account for this can have catastrophic effects. In October 1998, Long Term Capital Management, a hedge fund, lost billions of dollars partly due to using financial trading models that under-estimated market volatility.
A popular trading model that uses volatility in its computation is the Black Scholes option-pricing model. The formula, which lead to a Nobel prize in economics in 1997, is used widely to calculate the price of options contracts that give their owners the right to buy or sell financial assets such as stocks in the future at a fixed price.
Freitag, 12. Oktober 2001