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Why do some models behave badly?

By Hamish Johnston

In his latest book Models.Behaving.Badly: Why Confusing Illusion With Reality Can Lead to Disaster, on Wall Street and in Life, the physicist-turned-economist Emanuel Derman looks at how a superficial resemblance between the equations of physics and those of economics has led to confusion in the financial industry.

Yesterday, Derman was at the Institute of Physics in London to speak about the differences and similarities between models, theories and intuition. You can watch a video of his presentation above.

Derman did a PhD in particle physics before entering the world of finance back in 1985, when he joined Goldman Sachs. In 2004 he wrote the highly regarded book My Life as a Quant: Reflections on Physics and Finance.

Today, the New York-based South African splits his time between the engineering department at Columbia University – where he is Professor of Professional Practice – and Wall Street, where he is Co-Head of Risk at Prisma Capital Partners.

The take-home message of the talk is that financial models are never theories, rather they are metaphors. As such,  financial modellers must explain the shortcomings of their models to the rest of the world.

To encourage openess and honesty from the modelling community,  Derman and the mathematican and modeller Paul Wilmott published the Financial Modelers’ Manifesto in 2009. The 1300-word document ends with “The Modelers’ Hippocratic Oath”. My favourite line in the oath is the first, which reads “I will remember that I didn’t make the world, and it doesn’t satisfy my equations.”

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