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.
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This is an outline of the book:
Quants, physicists working on Wall Street as quantitative analysts, have been widely blamed for triggering the recent financial crisis with their complex mathematical models. What made these models, employed to minimize financial risk, so dangerous?
In this penetrating, insider's look at the recent economic collapse, Emanuel Derman--former head quant at Goldman Sachs and a former physicist--explains the collision between mathematical modeling and economics that has touched every one of us. Though financial models imitate the style of physics and employ the language of mathematics, 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 of reality
Derman ranges widely over his first-hand experiences in practice and theory, to explain the financial tangles that have paralyzed the economy. With sharp metaphors and tremendous explanatory power,he conveys the essence of these daunting financial models--The Black Scholes Model, The Efficient Market Model, the Capital Asset Pricing Model, etc--in very human terms.
Derman clearly shows us the intrinsic deficiencies of all models and explains why Wall Street, in its love affair with them, has a blindspot that prevents it from recognizing that finance will never be physics and that it will never be possible to write down a model that encapsulates human behavior.
Emanuel Derman is a professor at Columbia University, director of the university's program in financial engineering, and a principal at Prisma Capital Partners. He was formerly a quant and managing director at Goldman Sachs, and the author of many widely used financial models. He lives in New York City.
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