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

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EMANUEL DERMAN is Head of Risk at Prisma Capital Partners and a professor at Columbia University, where he directs their program in financial engineering. He is the author of My Life As A Quant, one of Business Week’s top ten books of the year, in which he introduced the quant world to a wide audience.
 
He was born in South Africa but has lived most of his professional life in Manhattan in New York City, where he has made contributions to several fields. He started out as a theoretical physicist, doing research on unified theories of elementary particle interactions. At AT&T Bell Laboratories in the 1980s he developed programming languages for business modeling. From 1985 to 2002 he worked on Wall Street, running quantitative strategies research groups in fixed income, equities and risk management, and was appointed a managing director at Goldman Sachs & Co. in 1997. The financial models he developed there, the Black-Derman-Toy interest rate model and the Derman-Kani local volatility model, have become widely used industry standards.
 
In his 1996 article Model Risk Derman pointed out the dangers that inevitably accompany the use of models, a theme he developed in My Life as a Quant. Among his many awards and honors, he was named the SunGard/IAFE  Financial Engineer of the Year in 2000. He has a PhD in theoretical physics from Columbia University and is the author of numerous articles in elementary particle physics, computer science, and finance.

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CHAPTER 1

A FOOLISH CONSISTENCY

Models that failed • Capitalism and the great financial crisis • Divining the future via 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

Pragmatism always beats principles. . . . Comedy is what you get when principles bump into reality.

—J. M. Coetzee, Summertime

MODELS THAT FAILED I: ECONOMICS

“All that is solid melts into air, all that is holy is profaned, and man is at last compelled to face, with sober senses, his real conditions of life, and his relations with his kind,” wrote Marx and Engels in The Communist Manifesto in 1848. They were referring to modern capitalism, a way of life in which all the standards of the past are supposedly subservient to the goal of efficient, timely production.

With the phrase “melts into air” Marx and Engels were evoking sublimation, the chemists’ name for the process by which a solid transmutes directly into a gas without passing through an intermediate liquid phase. They used sublimation as a metaphor to describe the way capitalism’s endless urge for new sources of profits results in the destruction of traditional values. Solid-to-vapor is an apt summary of the evanescence of value, financial and ethical, that has taken place throughout the great and ongoing financial crisis that commenced in 2007.

The United States, the global evangelist for the benefits of creative destruction, has favored its own church. When governments of emerging markets complained that foreign investors were fearfully yanking capital from their markets during the Asian financial crisis of 1997, liberal democrats in the West told them that this was the way free markets worked. Now we prop up our own markets because it suits us to do so.

The great financial crisis has been marked by the failure of models both qualitative and quantitative. During the past two decades the United States has suffered the decline of manufacturing; the ballooning of the financial sector; that sector’s capture of the regulatory system; ceaseless stimulus whenever the economy has wavered; taxpayer-funded bailouts of large capitalist corporations; crony capitalism; private profits and public losses; the redemption of the rich and powerful by the poor and weak; companies that shorted stock for a living being legally protected from the shorting of their own stock; compromised yet unpunished ratings agencies; government policies that tried to cure insolvency by branding it as illiquidity; and, on the quantitative side, the widespread use of obviously poor quantitative security valuation models for the purpose of marketing.

People and models and theories have been behaving badly, and there has been a frantic attempt to prevent loss, to restore the status quo ante at all costs.

THEORIES, MODELS, AND INTUITION

For better or worse, humans worry about what’s ahead. Deep inside, everyone recognizes that the purpose of building models and creating theories is divination: foretelling the future, and controlling it.

When I began to study physics at university and first experienced the joy and power of using my mind to understand matter, I was fatally attracted. I spent the first part of my professional life doing research in elementary particle physics, a field whose theories are capable of making predictions so accurate as to defy belief. I spent the second part as a professional analyst and participant in financial markets, a field in which sophisticated but often ill-founded models abound. And all the while I observed myself and the people around me and the assumptions we made in dealing with our lives.

What makes a model or theory good or bad? In physics it’s fairly easy to tell the crackpots from the experts by the content of their writings, without having to know their academic pedigrees. In finance it’s not easy at all. Sometimes it looks as though anything goes. Anyone who intends to rely on theories or models must first understand how they work and what their limits are. Yet few people have the practical experience to understand those limits or whence they originate. In the wake of the financial crisis naïve extremists want to do away with financial models completely, imagining that humans can proceed on purely empirical grounds. Conversely, naïve idealists pin their faith on the belief that somewhere just offstage there is a model that will capture the nuances of markets, a model that will do away with the need for common sense. The truth is somewhere in between.

In this book I will argue that there are three distinct ways of understanding the world: theories, models, and intuition. This book is about these modes and the distinctions and overlaps between them. Widespread shock at the failure of quantitative models in the mortgage crisis of 2007 results from a misunderstanding of the difference between models and theories. Though their syntax is often similar, their semantics is very different.

Theories are attempts to discover the principles that drive the world; they need confirmation, but no justification for their existence. Theories describe and deal with the world on its own terms and must stand on their own two feet. Models stand on someone else’s feet. They are metaphors that compare the object of their attention to something else that it resembles. Resemblance is always partial, and so models necessarily simplify things and reduce the dimensions of the world. Models try to squeeze the blooming, buzzing confusion into a miniature Joseph Cornell box, and then, if it more or less fits, assume that the box is the world itself. In a nutshell, theories tell you what something is; models tell you merely what something is like.

Intuition is more comprehensive. It unifies the subject with the object, the understander with the understood, the archer with the bow. Intuition isn’t easy to come by, but is the result of arduous struggle.

What can we reasonably expect from theories and models, and why? This book explains why some theories behave astonishingly well, while some models behave very badly, and it suggests methods for coping with this bad behavior.

OF TIME AND DESIRE

In “Ducks’ Ditty,” the little song composed by Rat in Kenneth Grahame’s The Wind in the Willows, Rat sings of the ducks’ carefree pond life:

Everyone for what he likes!

We like to be

Heads down, tails up,

Dabbling free!

Doubtless the best way to live is in the present, head down and tail up, looking at what’s right in front of you. Yet our nature is to desire, and then to plan to fulfill those desires. As long as we give in to the planning, we try to understand the world and its evolution by theories and models. If the world were stationary, if time didn’t pass and nothing changed, there would be no desire and no need to plan. Theories and models are attempts to eliminate time and its consequences, to make the world invariant, so that present and future become one. We need models and theories because of time.

Like most people, when I was young I couldn’t imagine that life wouldn’t live up to my desires. Once, watching a TV dramatization of Chekhov’s “Lady with a Lapdog,” I was irritated at the obtuse ending. Why, if Dmitri Gurov and Anna Sergeyevna were so in love, didn’t they simply divorce their spouses and go off with each other?

Years later I bought a copy of...