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

Derman, Emanuel

Hardcover

ISBN 10: 1439164983 ISBN 13: 9781439164983

Publisher: Free Press, 2011

Synopsis

Emanuel Derman was a quantitative analyst (Quant) at Goldman Sachs, one of the financial engineers whose mathematical models became crucial for Wall Street. The reliance investors put on such quantitative analysis was catastrophic for the economy, setting off the ongoing string of financial crises that began with the mortgage market in 2007 and continues through today. Here Derman looks at why people-- bankers in particular --still put so much faith in these models, and why it's a terrible mistake to do so.

Though financial models imitate the style of physics and employ the language of mathematics, ultimately they deal with human beings. 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 to it. When we make a model involving human beings, we are trying to force the ugly stepsister's foot into Cinderella's pretty glass slipper.  It doesn't fit without cutting off some of the essential parts. Physicists and economists have been too enthusiastic to acknowledge the limits of their equations in the sphere of human behavior--which of course is what economics is all about.

Models.Behaving.Badly includes a personal account of Derman's childhood encounters with failed models--the oppressions of apartheid and the utopia of the kibbutz. He describes his experience as a physicist on Wall Street,  the models quants generated, the benefits they brought and the problems, practical and ethical, they caused. Derman takes a close look at what a model is, and then highlights the differences between the successes of modeling in physics and its failures in economics.  Describing the collapse of the subprime mortgage CDO market in 2007, Derman urges us to stop the naïve reliance on these models, and offers suggestions for mending them.  This is a fascinating, lyrical, and very human look behind the curtain at the intersection between mathematics and human nature.

About this title

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.

From the Inside Flap

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.


Emanuel Derman is a professor at Columbia University, director of the university's program in financial engineering, and a principal at Prisma Capital Partners. He was formerly a quant and managing director at Goldman Sachs, and the author of many widely used financial models. He lives in New York City.

Edition details

• Publisher: Free Press
• Publication date: 2011
• Language: English
• ISBN 10: 1439164983
• ISBN 13: 9781439164983
• Binding: Hardcover
• Number of pages: 240