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| CSIRO | SOLVE | Issue 11 | MAY 07 | |
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ARTICLE
By Dr Gio Braidotti
CSIRO has been applying its mathematics expertise to develop financial derivatives products that help manage market risks.Equations that helped Einstein describe atoms have found finance market applications; in particular, managing risk in the derivatives market. They have brought CSIRO into the business of providing research, consultancy services and software to the financial sector – these days the third-largest sector in the economy. At CSIRO’s Quantitative Risk unit, Dr Zili Zhu typifies the new breed of ‘finance scientists’. Formerly a naval engineer who worked to silence submarine propellers, Dr Zhu is now applying his experience with ‘fluid mechanics’ to design software such as REDITUS for the valuation of currency options, especially the exotic variety.
“REDITUS is a financial derivatives option-pricing software,” Dr Zhu says of the stand-alone package, first released in 1999, which is now used by several large international banks. “More recently we released a REDITUS plug-in that integrates with FENICS FX – the market standard for pricing and analysing foreign exchange options.” Now, with more than 100 users, Dr Zhu is understandably proud of the software’s unique capabilities, which include the capacity to price instruments in equity, interest-rate and commodities markets. “A major US hedge-fund firm has just commissioned us to provide exotic options models,” Dr Zhu says. “We are constantly upgrading the software’s capabilities, and because we work with companies around the world, we gain valuable information about advanced financial instruments, which helps to drive our R&D program, which in turn directly benefits the Australian financial industry.” As to why there is an affinity between the movement of share prices and the chaotic, incessant motion of molecules – so-called Brownian motion – Dr Zhu actually thinks it is just a coincidence. “In the 1990s we developed an engine to solve partial differential equations related to turbulence and combustion. We then realised we could use the same fundamental method to solve what is perhaps the most famous formula in finance, the Black–Scholes option-pricing model.” To Dr Zhu, the value of solving the pricing problem scientifically is that it ‘takes the betting out’ of derivatives. That means an enhanced ability to differentiate risk and allocate it to those investors most able to take it. This has allowed an explosive growth in the size and complexity of the derivatives market.
With 17 other scientists working on financial applications besides Dr Zhu, measuring risk in other sectors, such as in portfolio management, and deciding whether to take the risk is a key R&D topic at CSIRO Mathematical and Information Sciences. Still, the scientists whose sojourn into finances started in the physical sciences may be about to turn full circle. As the broader economy attempts to deal with the effects of drought and climate change, the CSIRO team is exploring the possibility of modelling a trading scheme for carbon and water. It is just a proposal at this stage, Dr Zhu says, but his expertise with turbulence in fluids may yet find applications in other sectors, including the environment. For further information contact: |
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