Namibia has one of the most sophisticated, diverse, and highly developed financial systems in Africa according to the Namibian Financial Sector Strategy (NFSS): 2011-2021.
The financial system consists of the financial markets, financial intermediaries and other financial institutions that execute the financial decisions of households, firms/businesses and governments. In fact, the financial system is made up by four key elements: (1) lenders and borrowers; (2) financial institutions; (3) financial instruments and (4) financial markets.
Financial market is the institutional arrangement, mechanisms and conventions that exist for the issuing and trading of financial instruments. A financial instrument is a promise to pay money in the future in exchange for present funds.
A derivative security is a financial instrument whose value is derived from an underlying variable, such as a stock price, the level of an index, or an interest rate. Derivative instruments are used to transfer or mitigate risks.
The Bank for International Settlements described derivatives as valuable tools for financial risk management. It for this reason that derivative market is quite a huge one with trillions of dollars’ worth of outstanding contracts in the Over-the-Counter (OTC) markets.
What is mathematical finance, then?
Mathematical finance (sometimes referred to as quantitative finance) is a field of study of financial markets. It is a broad multidisciplinary field of applied mathematics that extensively draws on techniques from probability theory, statistics, scientific computing and partial differential equations to develop models and derive relationships between fundamental variables, such as asset prices, market movements and interest rates.
This field was developed in early 1970’s using the idea of complete market, derivative replications and no-arbitrage arguments by Merton, Black and Scholes.
This led to a better understanding of risk diversification, hedging and to remarkable pricing formulae for derivative securities in the financial market. Financial mathematicians (usually called quantitative analysts or quants) apply martingale (fair game) theory to make good decisions in the face of uncertainty and to realise that an asset’s price can be represented as an expectation under a special probability measure, called a risk-neutral measure.
Motivation of mathematical finance
The field emerged from the increasing sophistication of the understanding of market behaviour, because of advance in technology. It helps with the invention of new efficient methods to understand and manage new forms of risks.
The increasing integration of financial markets around the world has led to greater inter-dependence of market and country-specific markets being incapable of insulating themselves from international effects.
It is known that Namibian economy (e.g. exchange control rate) is strongly related to the South African economy. Although South Africa retains some version of exchange control, a gradual relaxation of these controls have been observed. Like South Africa, Namibia is also moving towards a freely traded currency.
Currency (options) derivatives can be a quite challenge in the financial market because they are linked to a particular currency pair in the foreign exchange market. To meet the country’s objectives it is crucially important that market participants in Namibia are as sophisticated in training as their international counterparts.
Furthermore, the derivative market in Namibia is still under-developed. It is a national goal to have a well-developed financial market to assist with developing local money and other market developmental issues. To attain these goals, the use of derivatives instruments must come into play.
Derivative market usually consists of hedgers, speculators and arbitrageurs as market participants. In Namibia’s case, the market is dominated by the spot or cash market ( e.g. interest – bearing markets such as foreign exchange and debt securities).
These securities present a unique challenge because of their multi-dimensional nature. In general, the pricing and hedging of these financial derivatives is rapidly becoming an extreme non-trivial mathematical exercise. A highly technical understanding of using these instruments is required as huge amounts of money can be made or lost through mispricing.
Mathematical finance synthesises a highly technical and abstract branch of mathematics, measure theoretic probability, with practical applications that affect peoples’ everyday lives. By employing advanced mathematics, it is possible to develop the theoretical foundations of finance and economics.
Nowadays, the mathematical finance toolbox is indispensable to investment banks, insurance companies, corporate treasuries, hedge funds and regulatory agencies, who apply it to risk management, structuring financial products, portfolio management, and asset pricing.
Career in mathematical finance
Mathematical finance programmes exist because the techniques within the derivatives pricing and risk management industry are becoming more mathematical and rigorous. In order to develop new exotic derivative instruments, as well to understand how to price and hedge them, the knowledge of mathematical finance is useful. Also from the credit crisis of 2008-9, the financial industry turned to academia.
This has led to the formation of mathematical finance research centres mainly focused on issues relating to derivatives pricing models, risk analysis “counterparty risks” and quantitative trading.
Moreover, based on these emerging economies, highly talented mathematics students and Namibian financial institutions should consider this field because the skill will be vital for economic development.
The University of Namibia is offering a BSc (Hons) programme in mathematical finance, which is self-contained and tailored to meet industry needs. It is, therefore, vital for Namibian financial institutions to engage with that academic programme by giving research projects and internships to final-year students.
It is only then we can have a well-developed financial market, which helps moderate boom-bust cycles that can be triggered by surges and sudden stops in international capital flows.
Lastly, investment banks, insurers and asset management companies require new financial products to give them an edge in the market. These are amongst the largest employers of people with advanced qualifications in mathematical finance outside academia.
* Mesias Alfeus is a mathematical finance (MSc. cum laude) graduate of Stellenbosch University.