Overview
The broad area of study within which my research proposal falls will be in the financial crisis that is being witnessed in almost every economy around the world. The current financial crisis affecting many countries around the world has become the focus of attention for many stakeholders within the financial sector. The thesis for my study will be to critically evaluate how quantitative models of accounting have contributed to the financial crisis. The motivation behind this study lies in the desire to understand why and how the economies of many countries around the world, especially in the Middle East, have been shaken to the core by the current financial crisis to a point of going to recession. According to a senior financial analyst with the Cambridge group, the prevailing financial crisis has created a deep recession in the US that has never been witnessed since the World War II (Wallack 2008). Financial stocks continue to spiral downwards, spelling doom even for large corporations.
The situation is the same the world over. Although Saudi Arabia is the world’s largest producer and exporter of crude oil and other related petroleum products, it has to keep on altering its interest rates to shun an economic implosion (International Credit 2008). Liquidity has been an issue in its financial sector as the government has to keep on interfering to curtail the Kingdom from submitting to complete illiquidity. This study is motivated by the desire to unearth the real factors behind such a meltdown in the financial sector.
Study Aims and Key Research Questions
This study aims at exploring the factors that have led to the financial collapse that continue to rock many economies around the world by performing a critical evaluation of how quantitative models have contributed to the financial crisis. The study aims at utilizing both the Option Pricing Theories (OPT) and Modern Portfolio Theory in its attempt to show how quantitative models in accounting have contributed to the financial crisis being witnessed in the world. Emphasis will be given to the Middle East in general and Saudi Arabia in particular, and the factors that have led to the financial meltdown in key institutions of the economy in the region. However, comparisons would be made of the financial situation in the Middle East with other major economies, especially the US since it was the origin of the financial crisis.
The research questions that the study aims to explore include:
- Are the factors that led to the financial crisis in the Middle East the same as those in the USA and Europe?
- Are the financial institutions and poor monetary regulation really to blame for the financial meltdown as claimed by stakeholders in the financial Sector?
- How has the quantitative models contributed (or otherwise) to the financial crisis in global economies especially in the Middle East?
- How and why do major world economies keep falling into the same pitfall of recession time and again? Are the factors related?
- Can the remedies to the quantitative models be found? If yes, what are the remedies?
Review of Literature and Relevant Practice
According to JA Worldwide (2008), the current financial crisis affecting nearly all the countries in the world came into play when the US fell into recession in or around 2008 due to a rapid contraction of credit brought about by a rapid decline in housing prices. Occasioned by changes in consumer prospects, low-priced mortgage rates, and reduced adherence to the banking rules in the mortgage sector, the housing prices especially for single family homes sharply rose by over 200 percent between 1994 to 2006 (Deboer 2008). New real estate speculators were encouraged to enter into the market due to the impressive prices, thereby further driving the housing prices upwards. When piled onto other factors driving the housing prices up, the final speculative demand for housing brought forth a housing price bubble. But due to the dwindling international confidence in the US economy that started in 2006, the asset price bubble burst, thereby pushing some foreign investors out of the housing market in addition to drying up some of the foreign savings that were being held in the US. This marked the start of the slump in the housing market as upward pressure was piled on mortgage interest rates (Deboer 2008; Cooper 2008). This occasioned a credit crisis which later led to the current financial meltdown as fewer loans were being issued by financial institutions due to the falling asset value.
Accordingly, Holt (2008) argues that one of the most important causes of the financial crisis being experienced in the world lies in over-confident individuals and financial institutions that borrow and lend huge sums of capital and invest it in businesses, luxury objects, and homes during the foregoing periods of economic growth. According to Holt, such individuals and financial institutions tend to “believe that the general growth will continue forever without interrupting periods of economic decline.” But when periods of economic turn down finally arrives, individuals are unable to pay their mortgages while banks and other lending institutions are unable to recover the money lent thereby leading to collapse.
According to Frankel (2008), factors that contribute to financial crisis are the same the world over, and can therefore be used uniformly across nations – from the US to the Middle East. Such factors includes underestimated risks in the financial markets, excessive leverage in financial institutions, failure of corporate governance, easy monetary policy, stock market bubble, predatory lending by financial institutions, excessive complexity, governments’ budgetary deficits, low national savings, foreign debts, and lower long-term economic growth.
The financial crisis in the US affected all the corners of the world, the Middle East included. The economies of most Middle East nations are mostly driven by the revenues of oil and oil products. But despite the high demand that oil attracts from other countries, these nations did not escape the financial crisis rocking the world. Late last year, some Middle East nations which previously thought that they were immune from international financial meltdowns started to bail out their banks as a direct result of what was happening in the US. In the United Arab Emirates, the Central Bank pumped in some $17.5 billion to local financial institutions to insulate them from the financial mess (TMO 2008). These countries had to be affected by the meltdown as Arab investors had a combined $800 billion in investments abroad, most of it invested in the US. Arab stock markets traded at their lowest towards the close of last year, with the Tadawul All-Shares index finishing at its lowest in more than four years. One of the possible explanations for this, according to TMO is that nearly all the economies of the developing countries sorely depend on the US to buy their imports as it is the world’s largest importer. As such, these countries would have to pay more with the weakening of the dollar.
The recession and financial crisis enveloping world economies have important implications on the economy of Saudi Arabia. According to reliable sources, the budget will fall into a deficit, projects will be delayed, and growth will be slow (Jadwa Investment 2008). Due to the meltdown, the government is planning to regulate the financial sector as well as introduce a mortgage market as a long-term policy measure. Overall, the financial situation in Saudi Arabia has worsened as inter-bank interest rates have sharply risen since June last year. Banks are reluctant to lend money as they are concerned with filling up their balance sheets. But unlike in the US where banks are collapsing, no Saudi bank has been seriously threatened by the prevailing financial crisis.
The harsh global and local financial situation has successfully frozen the debt financing markets in Saudi Arabia (Jadwa Investment 2008). Ever since the beginning of summer, there has been no new syndicated loan deals or Sukuk as it is popularly known. Just like in major economies around the world, raising money through the stock and equity market in Saudi Arabia has completely lost its attractiveness due to the prevailing financial crisis. As expected, the stocks in the country have sharply fallen, going down by over 48 percent since June last year to hit its lowest point in five years (Jadwa Investment). Companies that need to raise additional finance are faced with a bleak future due to the financial meltdown. Due to the prevailing global phenomenon, oil prices in Saudi Arabia have plummeted, commodity prices have collapsed, and the Kingdom is set to record slow economic growth and reduced external surplus.
According to the Accounting Dictionary (2008), a quantitative model refers to a collection of statistical and mathematical techniques used in solving some of the decision-making and managerial problems. This study will make use of the Option Pricing Theories (OPT) and Modern Portfolio Theory (MPT) to show how quantitative models contributed to the financial meltdown that is currently being experienced in world economies.
The Modern Portfolio Theory is by far one of the most influential and important economic theories dealing with investment and finance. The theory was developed by Harry Markowitz in 1952 (McClure 2009). Its basic premise is that an investor must invest in more than one stock to reap the maximum benefits of diversification as it is rarely enough to expect risk and return by only investing in one particular stock. By investing in more than one stock, the assumption is that risk to the portfolio is reduced. In a layman’s language, the theory warns investors not to put their eggs in a single basket. When they buy a stock, most investors take the risk that the return of the stock will be lower than previously expected. In other words, the stock will deviate from the average return. This is what the MPT calls a ‘risk’ or a standard deviation from the mean.
This theory assumes that the risk inherent in holding any single stock is far much bigger than the risk in a portfolio of diverse individual stocks. It is very creative in arguing that overall risk of portfolio is largely reduced when you add one risky asset to another one (McClure, 2009). In this sense, Markowitz tried to show that investment was about choosing the right combination of stocks, not just about picking stocks. Accordingly, MPT assumes that the risks for individual stock returns have two components; systematic risk (market risks that cannot be diversified away) and unsystematic risks (risks that can be diversified away as they are specific to individual stocks).
In the financial sector, the Option Pricing Theory (OPT) involves the analysis of the pricing of contracts to sell or buy a security or a commodity within a declared period of time and at a particular price. The process of selling is referred to as a put option while that of selling is referred to as the call option (Fabozzi 2001) The theory received some major reconstructions in the 1970’s though it was brought to the fore by the French economist Louis Bachelier (1870 – 1946). OPT is built on the principle that a replicating portfolio can be produced using risk-free lending and borrowing and the underlying asset (Applications 2005).
Methodology
This study aims at using interviews, Case study, Questionnaires and a survey of some financial institutions. However, the study aims at benefiting much from a case study to evaluate the factors that has really contributed to the financial crisis especially in the Middle East. Questionnaires and interviews will be used to supplement each other, and will be administered to key individuals in the banking and equity market. Given the set-up of this study, I propose to use a triangulated approach that will draw heavily on both quantitative and qualitatative research methodologies. The ultimate purpose of these approaches would be to give a qualitative score or index that can be compared to the mathematical formulas of the two proposed models to see if they have really contributed to the financial crisis.
Steps that will be taken in data collection will include administering a series of qualitative interviews to executives in the financial sector in an attempt to identify the causative factors of the financial meltdown. Questionnaires will be administered to gather quantitative data. The questionnaire will first be piloted before being administered to the chosen respondents. Several equity firms will be selected for the purposes of testing the two quantitative models and the qualitative data achieved would be used to determine the results. Afterwards, quantitative data will be analyzed using the various statistical software packages found in the method while qualitative data will be analyzed through the layering themes technique as well as through financial modeling technique.
Conclusion
This research will contribute to the expansion of the already existing data on financial crisis. But it will also bring a new dimension to the already existing body of knowledge in that it will aim at directly comparing how the selected quantitative models have contributed to the financial meltdown especially in the Middle East and Saudi Arabia. The research will serve posterity by unearthing the factors that have made the current financial crisis to be more intense than other previous financial crisis that have been witnessed.
References
Accounting Dictionary 2008 Quantitative Methods (Models). Answers.com. Web.
Applications of Option Pricing Theory to Equity Valuation 2005. Web.
Bourland, B 2008. Saudi Arabia and the Global Financial Crisis. Web.
Cooper, G 2008. The Origins of financial Crisis: Central Banks, Credit Bubbles and Efficient Fallacy. Harriman House.
Deboer, D.R 2008. Understanding the Financial Crisis: Origin and Impact. Department of Economics, CU – Colorado Springs
Fabozzi, F.J 2001. The Handbook of Fixed Income Securities. McGraw-Hill Professional.
International Credit Crisis Hits Saudi Arabia 2008. Web.
Jandwa Investment 2008. Saudi Arabia and the Global Financial Crisis. Holt, K 2008. Financial Crisis – Dynamics and Causes. Web.
McClure, B 2009. Modern Portfolio Theory: An Overview. Investopedia. Web.
Pitzke, M 2008. The World as we know it is Going Down. Web.
TMO 2008. Middle East Hit by US Financial Crisis. Muslim Media Network. Web.
Wallack, T 2008. “Recession is Here, Economist Declares.” The Boston Globe. Web.