Is the next financial crisis coming?

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Overview of the topics

  • Stocks Highlights: A 2018 tweet from Elon Musk might have caused between $4 billion and $11 billion of investment damages.
  • Financial Data: Even if the Black-Scholes equation contributed to the growth of the derivatives market, its misuse caused the 2008 crisis.
  • Economic Data: In 2008 the US gross domestic product fell by 4.3%, making it the deepest recession since World War II.
  • Social Data: Births between 2007 and 2009 decreased by 4% among women aged 15-44, with the largest drop for the ones aged 20-24.
  • Deep Dive: The current decrease in the supply of money could result in the instability of the worldwide financial system.

Stocks Highlights

A Tweet can make billions of $ in damages

During the latest trial involving Tesla a high-level panel of experts estimated that a 2018 tweet in which Elon Musk declared to have the financing to take Tesla private may have caused billions of dollars in investor damages.

As Elon Musk wasn’t found accountable for redirecting investors’ opinions, the jury hasn’t precisely established the amount of damages suffered by the shareholders. Economist Michael Hartzmark revealed, however, that in a 10-day period, the loss could have been between $4 billion and $11 billion. At that time, the price of Tesla shares ranged from $22.55 to $66.67.

With this respect, finance Professor Steven Heston analyzed the impact of Musk's tweets on more than 2,000 types of stock options using the Black-Scholes model. After the analysis, Heston concluded that it deviated from reality and declined to estimate the damages.

Financial Data

What is the Black-Scholes equation?

The Black-Scholes equation, developed by economists Fischer Black and Myron Scholes, provides a method for pricing financial contracts and deals with the growth of derivatives. When the mortgage market crashed in 2008, the derivative market caused turbulence in the worldwide banking system. For its contribution to the financial crisis, the equation is also reminded as the Black-Hole equation.

Even if the Black-Scholes equation is a tool for pricing financial derivatives and isn’t the root cause of the crisis, its potential for abuse led to its misuse. The financial sector saw the formula as a means of making everything turn to gold and didn’t consider the consequences of relying too heavily on it. Hence, the equation became a key factor in the growth of the derivatives market, but also a major contributor to the financial crisis.

The Black-Scholes equation provided the basis for the rapid growth of the financial industry. By 2007, the global financial system was indeed trading derivatives worth a staggering one quadrillion dollars per year. The growth, however, came at a cost. The creation of increasingly complex instruments made it difficult to assess their value and risk. For this reason, companies hired mathematical experts to develop new formulas but failed to consider the reliability of these formulas under changing market conditions. As a result, there was a financial crisis, in which the real value and risks of these instruments became unclear, leading to a global economic slowdown.

How does the Black-Scholes equation work? It applies to the simplest and oldest derivatives, represented by options. However, there are two kinds of options. A put option gives to the buyer the right to sell his commodity at a specified time for an agreed price. A call option is similar, but it confers the right to buy instead of sell. The equation gives a systematic way to compute the value of an option before it matures. Then the option can be sold at any time.

The purpose of the equation is to estimate the value of a derivative, but the key to making money is to have a better estimate of the derivative’s value than the market. In fact, if everyone agrees on the correct value, there is no opportunity for profit. However, the equation requires the investor to make several assumptions, and the assumptions can impact the accuracy of the estimate. In the derivatives market, only a small percentage of traders are successful, and the majority of traders lose their money. Hence, the loss of hundreds of billions of dollars by banks during the subprime crisis was due to incorrect estimates of the value of derivatives and not a flaw in the Black-Scholes equation itself.

Economic Data

The effects on the broader economy

The “Great Recession” was a consequence of the end of the period known as the Great Moderation, which was marked by decade-long expansions in the US housing market. When the market began to decline in 2006, it led to several losses in mortgage-related assets and strains in financial markets. In 2007, the US economy officially entered a recession and as a result, several financial firms faced financial distress.

The Federal Reserve intervened by providing support and liquidity to the markets in an effort to limit the harm to the US economy. However, despite these efforts, the recession continued to worsen in the fall of 2008. The US economy bottomed out in 2009 but recovery was slow. The financial crisis even resulted in major reforms in banking and financial regulation and was able to affect the Federal Reserve through congressional legislation.

The housing sector was the driving force behind not only the financial crisis but also the economic downturn. Residential investment and employment in the construction sector peaked in 2006, and the broader economy rose until December 2007, which is represented as the start of the recession by the National Bureau of Economic Research. The recession initially showed a modest decline in economic activity, but it steepened rapidly in the fall of 2008 due to financial market stress. The US gross domestic product fell by 4.3%, making it the deepest recession since World War II and lasting nearly 18 months. The unemployment rate more than doubled, from 5% to 10%.

In response to the worsening economic conditions, the FOMC, represented by the Federal Open Market Committee, lowered its target for the federal funds rate, and as the financial crisis intensified, it increased its interest rate cuts, eventually reaching the target range of 0 to 25 basis points by the end of 2008. The Federal Reserve initiated its first large-scale asset purchase program in November 2008 to reduce long-term interest rates and support economic activity.

Social Data

The crisis didn’t affect only the economy

The 2008 financial crisis had far-reaching consequences beyond just the economy. It led to widespread public mistrust in financial institutions and a decline in public confidence in the government's ability to regulate the US economy.

The crisis led to a rise in income inequality, as the wealthy were more likely to recover from the crisis than lower-income families, who suffered from job loss, mortgage foreclosures, and declining home values. For this reason, the resulting economic hardship fueled the growth of populist movements and political polarization. Another important effect was related to globalization because countries became more protectionist in their trade policies.

The most important consequences, however, regarded fertility rates. In fact, Sutton and colleagues found that births between 2007 and 2009 declined by 4 percent among all women ages 15 to 44, with the largest drop among women ages 20 to 24.16. However, such effects were not compensated by an increase in net migration rates, since they declined too.

In conclusion, the financial crisis of 2008-2009 highlights the importance of effective risk management, as well as its impact on economic development and the well-being of individuals. Worldwide policymakers need to prioritize the integration of risk management into development agendas, establish contingency planning mechanisms, analyze risk linkages, and set up social protection policies. These steps are crucial to prevent future financial crises and ensure sustainable economic growth and development.


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Deep Dive

What about the next financial crisis?

The next financial crisis could be near. The decline in the amount of money available in the shadow banking system has raised concerns and brought to light certain problems, according to Verena Ross, the head of the European Union's securities regulatory body.

In an interview, Ross warned that the decrease in the supply of money in the shadow banking system could result in the instability of the financial system and the broader economy. Invite 3 friends and gain access to the full deep dive!

News of the week

  • Banks: Credit Suisse warns of more losses after sliding deep into the red [Read more].
  • Technology: Here's how professionals in 3 different fields are using ChatGPT for work. [Read more]
  • Markets: Stocks fall as investors assess earnings and the path for rates. [Read more]
  • Investments: U.S. aims to curtail technology investment in China. [Read more]

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