Once in a lifetime events happened every day
Models. Behaving. Badly
By Emanuel Derman
DISTURBED, disillusioned, ashamed: Those aren't emotions you expect a Wall Street quant to express when asked why taxpayers were obliged to bail out wealthy bankers.
Unless, of course, the quant is Emanuel Derman, a particle physicist and former head of quantitative finance at Goldman Sachs.
"I am ashamed at the hypocrisies of the system," Mr Derman writes in 'Models.Behaving.Badly', an erudite yet pleasantly readable exploration of why financial models failed during the US mortgage meltdown and why modellers must learn to use them more wisely.
"We were told not to expect reward without risk, gain without the possibility of loss," he says in disgust. "Now we have been forced to accept crony capitalism, private profits and socialised losses, and corporate welfare."
Mr Derman says he wasn't surprised that models failed in 2007, as events predicted to happen "once in 10,000 years happened every day for three days", as one strategist at Lehman Brothers put it.
The breakdown, Mr Derman argues, flows from a misunderstanding of the difference between models and theories.
Theories are attempts to uncover the hidden principles underpinning the world around us, as Albert Einstein did with his theory of relativity. Models, says Mr Derman, are metaphors -- analogies that describe one thing relative to another. You can't have a grand unified theory of securities, he says, because markets are driven by ephemeral human opinions.
As the coy punctuation in the title suggests, Mr Derman is interested in three things: models, models that behave, and models that behave badly. Designing a model based on human behaviour is like "trying to force the ugly stepsister's foot into Cinderella's pretty glass slipper", he says. "It doesn't fit without cutting off some essential parts."
That doesn't mean models are a waste of time, he says. It just means that we must use them with common sense.
In 'Models.Behaving.Badly,' Mr Derman, a professor at Columbia University, takes us on an intellectual journey that compares the glories of theoretical physics to the messiness of economics.
He begins with a notoriously flawed model -- the apartheid of his boyhood South Africa -- and then, quietly and unpretentiously, guides the reader through topics ranging from Baruch Spinoza's analysis of human passions to Paul Dirac's discovery of the positron as a hole in a sea of electrons.
Mr Derman has distilled a lifetime of research and thinking into these pages, and I read the book twice to see how he pulled the threads together without losing the reader.