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

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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.


About Emanuel Derman

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Emanuel Derman is a professor at Columbia University and Director of the university's program in financial engineering. Until his retirement in 2002, he spent sixteen years at Goldman Sachs as a quant.
Published October 14, 2011 by Wiley. 241 pages
Genres: Business & Economics, Science & Math, Law & Philosophy, Professional & Technical. Non-fiction

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Derman argues that these models fail to account for the human element, or what John Maynard Keynes called “animal sprits.” Drawing on his experience as a child in Apartheid South Africa, the author exposes the failure of models and theories when applied to politics.

Oct 15 2011 | Read Full Review of Models.Behaving.Badly: Why Co...

The Wall Street Journal

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The idea that significant arbitrage opportunities are unlikely to exist (and certainly do not persist) is precisely the mechanism behind the Black-Scholes option-pricing model that Mr. Derman admires as a financial model behaving pretty well.

Dec 14 2011 | Read Full Review of Models.Behaving.Badly: Why Co...


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models tell you merely what something is like.“ More than a description of what went wrong with models during the financial crisis, Derman describes what’s gone wrong with the use of them by those who infused models with omniscience.

Nov 14 2011 | Read Full Review of Models.Behaving.Badly: Why Co...

Chicago Tribune

The Black-Scholes Model for valuing stock options is, in turn, likened to making fruit salad: If you know the price of the fruit that goes into the salad (shares in, say, Tutti Frutti Bop Inc.), you know what the salad (an option on those shares) is worth.

Nov 07 2011 | Read Full Review of Models.Behaving.Badly: Why Co...

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