Models. Behaving. Badly.: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life

by Emanuel Derman

Overview

Quants, physicists working on Wall Street as quantitative analysts, have been widely blamed for triggering the recent financial crisis with their complex mathematical models. What made these models, employed to minimize financial risk, so dangerous?

In this penetrating, insider's look at the recent economic collapse, Emanuel Derman--former head quant at Goldman Sachs and a former physicist--explains the collision between mathematical modeling and economics that has touched every one of us. Though financial models imitate the style of physics and employ the language of mathematics, there is a fundamental difference between the aims and potential achievements of physics and those of finance. In physics, theories aim for a description of reality; in finance, at best, models can shoot only for a simplistic and very limited approximation of reality.

Derman ranges widely over his first-hand experiences in practice and theory, to explain the financial tangles that have paralyzed the economy. With sharp metaphors and tremendous explanatory power,he conveys the essence of these daunting financial models--The Black Scholes Model, The Efficient Market Model, the Capital Asset Pricing Model, etc--in very human terms.

Derman clearly shows us the intrinsic deficiencies of all models and explains why Wall Street, in its love affair with them, has a blindspot that prevents it from recognizing that finance will never be physics and that it will never be possible to write down a model that encapsulates human behavior.

Product Details

ISBN-13:	9781119944690
Publisher:	Wiley
Publication date:	10/13/2011
Sold by:	JOHN WILEY & SONS
Format:	eBook
Pages:	240
File size:	2 MB

About the Author

EMANUEL DERMAN is Head of Risk at Prisma Capital Partners and a professor at Columbia University, where he directs their program in financial engineering. He is the author of My Life As A Quant, one of Business Week's top ten books of the year, in which he introduced the quant world to a wide audience.
He was born in South Africa but has lived most of his professional life in Manhattan in New York City, where he has made contributions to several fields. He started out as a theoretical physicist, doing research on unified theories of elementary particle interactions. At AT&T Bell Laboratories in the 1980s he developed programming languages for business modeling. From 1985 to 2002 he worked on Wall Street, running quantitative strategies research groups in fixed income, equities and risk management, and was appointed a managing director at Goldman Sachs & Co. in 1997. The financial models he developed there, the Black-Derman-Toy interest rate model and the Derman-Kani local volatility model, have become widely used industry standards.
In his 1996 article Model Risk Derman pointed out the dangers that inevitably accompany the use of models, a theme he developed in My Life as a Quant. Among his many awards and honors, he was named the SunGard/IAFE Financial Engineer of the Year in 2000. He has a PhD in theoretical physics from Columbia University and is the author of numerous articles in elementary particle physics, computer science, and finance.

Table of Contents

I. MODELS

1. A Foolish Consistency 3

2. Metaphors, Models, and Theories 33

II. MODELS BEHAVING

3. The Absolute 73

4. The Sublime 107

III. MODELS BEHAVING BADLY

5. The Inadequate 139

6. Breaking the Cycle 189

Appendix: Escaping Bondage 201

Acknowledgments 205

Notes 207

Index 217