If you've got this far you will have read me complaining about some theories and practices of quantitative finance. This continues in this section. But if you've managed to resist throwing this book at the cat so far then you should make it through ok!
Most of these essays have been previously published in blog form, some of them as part of a 'Science In Finance' series. You will notice, because they are numbered, that some of these appear to be missing. That's to avoid repetition because those essays have been expanded upon and formed the basis for the FAQQF2 chapter on the commonest quant mistakes.
Science in Finance: Introduction
Having for most of my quant career attacked the majority of mathematical modelling in finance for being 'unscientific' (in the sense that the theories are rarely tested before being used, and when tested usually fail miserably) I feel somewhat heartened by the recent anti-Black-Scholes movement. Unfortunately this countermovement, although healthy in provoking debate, also does not quite match my (presumably rather high!) standards of rigour. With the aim of putting some science back into the quant debate I'm going to spend a few essays highlighting what I think are the weaknesses of financial modelling, and its strengths. I will even be defending Black-Scholes at times! Being scientific does not mean being without emotion, so although my reasoning will be logical my language will almost certainly, and as always, get quite demonstrative.
Topics to look out for, in no particular order: supply and demand; accuracy in different markets; distributions and fat tails; volatility and robustness; hedging errors; diversification; correlation; etc.
Science in Finance I Revisited: Supply and Demand, and Spoon Bending
I attended some of the recent Savoy auction by Bonhams and I couldn't resist observing the events from a quant perspective! In particular, I was drawn back again to the question of valuation versus supply and demand. We are taught that value comes from some complicated mathematical analysis involving lognormal random walks and stochastic calculus. However, we all ought to know that value comes about by a more obscure and more interesting and usually ad hoc procedure, often involving little logic and certainly no maths, and sometimes quite a lot of emotion. (Think women and shoes.) All of this was seen at the Savoy auction. Yes, there were people tut-tutting at the amount some were willing to pay for an ashtray, but they weren't those doing the buying. Those who bought the ashtrays probably had some doubts at the time, and also shortly afterwards, even this morning and maybe when they collect the ashtrays, but in the long run they'll at least have a funny story about themselves. (The latter not so easy to assign a value to, and certainly not risk neutral!)
Near the end of the three days there was a boring patch with 50 Savoy double beds going under the hammer, one after another. To amuse myself and in the spirit of scientific curiosity, I wrote down the 'time series of prices for these identical items, see Figure 4.1. Now here was a room full of the same people, bidding for identical items with a known and limited supply, but even in this rather dull scenario the results were interesting, the plot of the times series is shown. Observations: the price did settle down to a value around £50, but that wasn't exactly stable; absentee bids mostly caused dramatic increases in the price (I m sure economists will get excited about 'information at this point, but this was the least interesting observation); later absentee bids were very
low, people perhaps hoping for drying up of demand(?); a few lucky or clever people even got the price down below the £50; individual bidders did not seem to show consistency in their bidding; losing bidders often took a break for a few lots before coming back in. None of this is other than perfectly obvious (and much already covered in auction theory, I hope) but in my experience you really have to keep reminding quants that they are human beings as well, and that they should draw inspiration from the mundane.
I bumped into Uri Geller at the auction. He had just successfully bid for... you guessed it, spoons! He's a very nice gentleman, and very kindly gave a few of us a private display of spoon bending!
Figure 4.1: Bed price versus lot number at the Savoy auction.