Book description
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.
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.
