Christmas shocker: Derman on models!


Diagram of Schrodinger's cat theory. Roughly b... 

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NO…not those kind of models! No saucy snaps here. But there is a link to a great article from Gillian Tett (Financial Times) – highlighted by THE website for people seeking knowledge and informed opinion on important issues – for those “too blinkered” to see event the most obvious flaws in financial (and risk) modelling:

 

Derman adds, mean that models should be junked. They can be valuable if employed with five, key principles: firstly, financial models should avoid too much axiomatisation; secondly, they should be as “vulgar” as possible (meaning there should be “as direct a path as possible between observation of similarities and the consequences”). Thirdly – and crucially – they should “sweep dirt under the carpet but let users know about it” (i.e., tell everyone up front what has been ignored in the model assumptions.) Fourthly, model users should be trained to think of models as “Gedanken experiments”, used to illustrate a theory but never meant to be physically carried out – like Schrödinger’s cat. Last but not least, financial players must stop their “idolatry” of models; and, presumably, their worship of quants.

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