Thursday, May 10, 2012

Determining Particle Finance In Today's Economy

In the financial sector, wealth determines many things. However, taking a step back to determine wealth itself, introduces an interesting notion. Wealth is being created not by making and selling things, although this is still a large part of the economy, but by taking, trading, and managing risk in the financial sector. Because every asset carries some risk, the market creates ways to lay off the risks we don't want or can't bear to an insurance company or by the use of some financial derivatives. The idea of breaking down every risk into smaller and smaller parts was given the name particle finance, and modem technology is giving us the means to find the most efficient balance between risk and return.

Charles S. Sanford Jr, who coined particle finance, described it in this way: Risk management is the process of moving clients closer to their desired risk profiles by helping them shed unwanted risks or acquire new risks that suit their portfolios. At times, this can be done simply by matching a client who wants to shed a risk with one who wants to acquire that risk. More often, it involves unbundling, transforming, and repackaging risks into bundles tailors to fit the particular needs of various clients.

Many of the ways to manage risk turned out to be less than perfect and sometimes gave a false sense of security. The creation of all these new risk-sharing techniques has produced a whole new cottage industry. Hardly any of these derivatives would be possible without the power of the computer.
As economics change, the conventional wisdom often lags far behind reality. Thus, in today's world of rapid change, old maps and concepts of economic development will no longer help us navigate the waters of the new economy. In fact, they may prove to be as misleading as a map drawn by Gastaldi, the official mapmaker f the Venetian Republic, that showed the Strait of Anion, a body of water linking Hudson Bay with the Pacific Oceanthe so-called Northwest Passage.

Gastaldi's map was wrong, as no such body of water exists. Nevertheless, it had a profound effect on accelerating the exploration of the North American continent; one adventurer after another sought the fabled Northwest Passage in an effort to collect the huge prize offered by the British Admiralty.

Strictly speaking, there are no economic maps to the brave new world in which we live today, so we must determine at least its general shape without them. What we do know is that intellectual capital, the driver of the new economy can be leveraged indefinitely. Whereas fixed costs may be high, as in the production of a movie or the writing of a piece of software, the marginal cost of replication approaches zero.

Is this new economy just the same old economy with a few new twists or has there been a paradigm shift?

To a measurable extent, business strategies of the twenty-first century will be molded by the answer to that very question.

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