Models. Behaving. Badly.

Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life

Emanuel Derman

• Publisher: Wiley
• Year: 2011
• Print ISBN:
  9781119967163
• Edition: 1
• eBook ISBN:
  9781119944690
• Topic: Business
• Subtopic: Finance
• Index: Business

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.

Index

absence as presence

absolutes: and Derman’s four questions

fiat money example and

irreducible nonmetaphor and

love and desperation and

nature of theories and

passions and

perfection and

and Spinoza’s answers to Derman’s questions

Spinoza’s emotions theory and

Tetragrammaton and

abstractions

accuracy: of economic/financial models

of theories

action: at a distance

freedom of

understanding and

adequate causes

Adonai,

African Resistance Movement

airplane models

Akiva, Rabbi

algebra: fundamental theorem of

aliyah,

aliyah register

alpha: CAPM and

Amichai, Yehuda

Ampère, André-Marie

analogies

analytic continuation

Anderson, Carl

antiparticles

apartheid

apartments: valuing of

Apple stock

arithmetic: fundamental theorem of

artists’ models

Asian financial crisis

assumptions: in financial models

Modelers’ Hippocratic Oath and

rules for using models and

types of models and

unconscious

Atlas Shrugged (Rand)

atomic physics

axioms/axiomatization

bad. See evil

bailouts

bare electrons

Barfield, Owen

Bedazzled (film)

Begin, Menachem

behavior, human: adequate knowledge and

EMM as assumption about

explanations for

and humans as responsible for their actions

and idolatry of models

Law of One Price and

laws of

pragmamorphism and

Ben-Gurion, David

Bernoulli, Daniel

Bernstein, Jeremy

beta: CAPM and

Betar (Brit Yosef Trumpeldor)

binocular diplopia

birds

Black, Fischer

Black-Scholes Model

Merton and

Blake, William

Bnei Akiva (Sons of Akiva)

Bnei Zion (Sons of Zion)

body-mind relationship

Bohr, Aage

Bohr, Niels

bonds: financial models and See also type of bond

Boyle’s Law

Brahe, Tycho

brain

Brave New World (Huxley)

Brownian motion

bundling of complex products

cage: moth in perfect

calibra...

Table of contents

• Cover
• Dedication
• Title Page
• Copyright
• Model I
• Model II
• Model III
• Appendix
• Acknowledgments
• Notes
• Index
• About the Author