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 Partnersand a professor at Columbia University, where he directs theirprogram in financial engineering. He is the author of My Life AsA Quant, one of Business Week's top ten books of the year, inwhich he introduced the quant world to a wide audience.
He was born in South Africa but has lived most of his professionallife in Manhattan in New York City, where he has made contributionsto several fields. He started out as a theoretical physicist, doingresearch on unified theories of elementary particle interactions.At AT&T Bell Laboratories in the 1980s he developed programminglanguages for business modeling. From 1985 to 2002 he worked onWall Street, running quantitative strategies research groups infixed income, equities and risk management, and was appointed amanaging director at Goldman Sachs & Co. in 1997. The financialmodels he developed there, the Black-Derman-Toy interest rate modeland the Derman-Kani local volatility model, have become widely usedindustry standards.
In his 1996 article Model Risk Derman pointed out thedangers that inevitably accompany the use of models, a theme hedeveloped in My Life as a Quant. Among his many awards andhonors, he was named the SunGard/IAFE Financial Engineer of theYear in 2000. He has a PhD in theoretical physics from ColumbiaUniversity and is the author of numerous articles in elementaryparticle physics, computer science, and finance.
