I'm trying to answer the following questions.1. Does quantitative finance (QF) become obvious or necessary as capital markets mature? Why is it? 2. Does QF help generate a positive-sum game? Asked another way, what's its role in boosting the economy?Would you folks please help me on these questions and/or point me to well-researched references?Thanks.

I am not an expert on this but my guesses are:1. It is just like using bigger guns in wars. If you don't use it, you will die.2. What is a positive-sum game? Do you mean a win-win situation? Even stock market doesn't have win-win because you are actually gaining from someone who are later in the game. If you are talking about the value of QF, then I would say it makes the market more efficient because it eliminates arbitrage opportunities including statistical arbitrage.

1. Financial products have clearly become more complex over time. Add to that the dizzying improvement in computing power that empowers people to do more and more analysis. Add to that the increasing demands of regulators. Add to that the shrinking bid/offer spread in vanilla products that creates an incentive to price and hedge more accurately. These all add up to a bright future for the quantitative finance type.2. Much of the press about derivatives repeats the tautology that they are a zero sum game. But they also allow producers and consumers to hedge. They allow companies to finance at cheaper rates. By supporting the cash business QF aids capital formation, something essential to prosperity.There... today I come off sounding as a happy little corporate hamster rather than the experienced cynic that I actually am!

"Much of the press about derivatives repeats the tautology that they are a zero sum game."Watch Lou Dobbs for five minutes. He would have you believe derivatives are things that live under bridges and and eat old ladies on their way to church.

2. Definitely not zero sum! Superficially this appears true, for every buyer there is a seller etc. However, one side may be dynamically hedging with the underlying and this affects the behaviour of the underlying: hedging positive gamma decreases vol and hedging negative gamma increases vol. Behaviour of stocks on which there are convertible bonds is often cited as a benign example, with the '87 crash as the evil version. See Wilmott, P. and Schonbucher, P 2000 The feedback effect of hedging in illiquid markets. SIAM J. Appl. Math. 61 232—272, also PS's dissertation.I'll go along with the corporate-hamster view to some extent, but that doesn't explain the really weird contracts out there.Derivatives taken in excess and without a doctor's supervision are dangerous.P

Thanks for your feedbacks. Are there any reasons other than the feedback effect of hedging in illiquid markets?Do you guys have significant examples that can illustrate the role of QF in boosting the economy? Or do you know any econometrics papers that show positive correlations?What bothers me most is that quants tend to exploit on some kind of short-term arbitrages (for example, high frequency trading, dynamic hedging, etc.) rather than looking at the long-term prospect of companies or economics outlook. I tend to agree with the first reply: QF provides bigger guns in wars.

"one side may be dynamically hedging with the underlying" - but now you are trading in the underlying. The question is whether trading in the derviative is zero sum. Moreover, they "may" be dynamically hedging.Trading derivatives is zero sum. For every dollar my swap/option/etc goes up someone elses goes down. No value is created. If you sum all the gains and losses that take place in the futures market tomorrow, the sum will be zero.Free markets move capital from less productive to more productive businesses. You may argue that derivatives assist in this transfer, thereby having a positive effect on the economy. Then you have to try and prove this and get it in JPE.Further, derivatives may be used to reduce risk, thereby making firms more likely to invest in new plant and equipment thus creating value (real assets). Looking at the research of La Porta, better banking systems lead to faster economic growth, so here too derivatives may be creating value. One must also be careful defining a thing by what it "may" be used for. This may differ from what it is used for. This is a problem they have with cold medicine, while it may treat colds, it may also be turned into a street drug (and more often than not is when sold to someone at 3am in bulk). So derivatives can be used by airlines to hedge fuel costs or by companies to swap floating for fixed rates (helping to increase real assets), and can also be used to take obscene directional bets on the Euro Stoxx 50 (which destroys value if it unhinges the banking system).In other words, derivatives increase risk or decrease risk or perform any other legion purposes as is our whim. Their actual effect is an academic question.

merx,You will probably find some reluctance for people to sell certain derivatives if they are not permitted to dynamically hedge. (Not that it works particularly well anyway, but that is what people do, and that is what most pricing theory is based on. Static hedging with other derivatives is better, and does not cause such (in)stability problems.) The obvious analogy is that of bullets, fine on there own but people who tend to buy bullets also tend to own guns...so a theory of the benefits of a market for bullets that doesn't allow for their use in guns would be worthless.Your examples (hedging fuel costs, swapping fixed for floating) are not exactly 'weird'! I really think we have have to distinguish between contracts with natural benefits and those that are created for speculation with leverage. That should be the starting point perhaps. What do you think?Not sure what you mean by an 'academic question.' 'Academic' used in a pejorative sense, or only for 'academics' to answer? P

Paul,I certainly don't use "academic" pejoratively. I mean such questions are usually battered about in Finance/Econ departments. For instance: Are larger banking systems good? I would say this is an academic question insofar as it interests academics, however there may not be a direct way to make money with the answer (so practitioners are not so interested).Options are redundant securities, and so you can sell options and then replicate them as a hedge by trading in the underlying (the option and the hedge together earn the risk free rate and we get B-S). As you note not perfectly however, which is why we have options and don't just replicate them when we want one. However, what percent of options sold are hedged? I would be at a loss to ballpark the number.We don't price futures with replication arguments, and for some of course there are only bounds for the price. So when a farmer sells December wheat there is no dynamic hedging going on.I was just noting that when the financial press says derivatives are zero sum they mean all gains and losses in the derivatives cancel, which is true. However, I wouldn't be averse to a statement such as, "while the trading in derivatives is zero sum, such trading generally causes trading in the underlying as a hedge......which makes the totality of the trading caused by derivatives to not be zero sum".I would be for trading derivatives even if I personally couldn't find any natural benefits. Hayek may say something like, we dont have derivatives because one person reasoned that we have them but rather they evolved within the economy. In other words no central planner created wheat futures, some farmers (in Greece or Rome or wheresoever) just naturally made up the contract and they worked. If some derivative created turns out to be bad for the economy(was solely for the purpose of leverage when such leverage wasn't needed) I think people would stop trading it. Of course, I have been wrong and I realize I do sound a bit like Pangloss!