Models.Behaving.Badly: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life

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9781439164983: Models.Behaving.Badly: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life

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.

Die Inhaltsangabe kann sich auf eine andere Ausgabe dieses Titels beziehen.

From the Author:

This is an outline of the book:
Models.Behaving.Badly

  • Part I. Models

Chapter 1. A Foolish Consistency
 A personal account of my experiences with models that failed.

Models that failed *  Capitalism and the Great Financial Crisis * Divining the future: models, theories, and intuition * Time causes desire * Disappointment is inevitable * To be disappointed requires time, desire and a model * Living under apartheid * Growing up in "The Movement" * Tat Tvam Asi
Chapter 2. Metaphors, Models and Theories

The various ways we have of understanding the world and predicting its future. Theories tell you what something is. Models tell you merely what something is like. Intuition is a merging of the understander and the understood.

* Language is a tower of metaphors * The hole in the Dirac sea  * Metaphors become real: the discovery of the positron * Absence is a presence * Analytic continuation * Every fact is a theory * Building a model airplane * Why is a model a model? * Why is a theory a theory? * A puzzling case of monocular diplopia * Making the unconscious conscious again

  • Part II. Models Behaving

Chapter 3. The Absolute

An illustration of a theory: Spinoza's Theory of the Emotions

* The Tetragrammaton * The Name of the Name of the Name * The Irreducible Nonmetaphor * Spinoza's Theory of the Emotions * Fiat Money * How to Live in the Realm of the Passions
Chapter 4. The Sublime
Electromagnetism, a perfect theory. The role of intuition.

* The Birds of the Air * The Best Theory in the World * No Logical Path to It  * Electricity and Magnetism * Their Qualities * Their Quantitative Laws * Ampère's Sympathetic Understanding of the Phenomena * Faraday's Imaginary Lines of Force * Maxwell's Factual Field * The Beasts of the Field

The ultimate goal would be: to grasp that everything in the realm of fact is already theory.                         Goethe,Maxims and Reflections
  • Part III. Models Behaving Badly

Chapter 5. The Inadequate
The efficient market model: a model and an analogy but NOT a valid theory.

* Financial models are not the physics of markets  * In finance, uncertainty is everywhere * The difference between uncertainty and risk * The Efficient Market Model  * The relation between risk and return * Risk is like pleasure * The Black-Scholes Model * CAPM * Alpha and beta * Why the Efficient Market Model fails * The unbearable futility of modeling


There is nothing so terrible as activity without insight.        
Goethe,Maxims and Reflections


Chapter 6. Breaking The Cycle

How to cope with the inadequacies of models, via ethics and pragmatism.

* The Perfect Cage * The Mysteries of the World * Models That Failed * How to use financial models * Beware of Idolatry * The Financial Modelers' Manifesto * Markets and Morals * Tat Tvam Asi

From the Inside Flap:

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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