HOW NOT TO FALL FOUL OF THE MODEL MAKERS

[ Wed. Dec. 22. 2010 ]

his Christmas, a bevy of elegant models are on display. Not just the long-legged female variety (although you can see those at this season’s parties in New York); instead, regulators, bankers and investors have been flaunting their own smart models, as they attempt to predict what 2011 might deliver.

But as this economic catwalk gets underway, it is shot through with irony. When the financial crisis hit, many observers blamed the disaster on the misuse of financial models. Not only had these flashy computer systems failed to forecast behaviour in the sub-prime mortgage world, but they had also seduced bankers and investors to take foolhardy risks or been used to justify some crazy behaviour.

But these days, in spite of all those mis-steps, there is little sign that financiers are falling out of love with those models; on the contrary, if you flick through the recent plethora of reports from the Basel Committees — or look at the 2011 forecasts emanating from investment banks — these remain heavily reliant on ever-more complex forms of modelling.

So what are investors to make of this? One particularly thought-provoking set of ideas can be seen in the current work of Emanuel Derman, a former physicist-turned banker who shot to fame within the banking industry two decades ago by co-developing some ground-breaking financial models, such as the Black-Derman-Toy model (one of the first interest rate models) and the Derman-Kani local volatility model (the first model consistent with the volatility smile). *

At first glance, Derman’s past might suggest he should be a model-lover — or "modeliser" — par excellence. In the banking world, he is often hailed as one of the great, original "quants", who paved the way for the derivatives revolution. Yet in reality, Derman has always been pretty cynical about those models that won him, and other quants, earlier accolades. For while investment bank salesmen might have treated his creations as near infallible, in truth Derman — like many brilliant scientists-turned-quants — has always recognised their flaws. ...

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