It Is and It Isn't
I couldn't resist this rather trivial note, just a comment really on happenings at a recent quantie dinner. In attendance, going clockwise around the table at Union Square Cafe, PW, Bruno Dupire, Salih Neftci, Peter Carr, Jim Gatheral and Emanuel Derman.
Discussing the validity of all this Black-Scholes stuff that has got so much bad press recently, JG says 'I have a nice apartment in **** thanks to Black-Scholes being correct' to which yours truly responded 'Well, I have a nice flat in **** thanks to it being wrong!' Now, you can sort of see how that can be! It depends upon (a) to what use you put BS and, crucially, (b) how much profit margin you can add to any deal!
Not naming any more names, it was clear from the rest of the conversation (which concerned numerical integration in infinite-dimensional spaces!) that, if this sample is to be trusted and extrapolated, (a) half of all quants actually believe all this math finance modelling nonsense, (b) one third of all quants don t, and are rather concerned for the mental health of the first half, and (c) one sixth of all quants either don t care or have maybe been enjoying the excellent wine list at Union Square Cafe too much!
This is No Longer Funny
I've been critical of much of quant modelling for many years. I don t like the assumptions, the models, the implementations. I've backed this up with sound reasons and wherever possible tried to find alternative approaches that I think are better. I don t honestly expect to change the world, much, but, hey, I do what I can. Human nature is such that very often things have to go from bad to worse to bloody awful before the necessary paradigm shift happens. I hope we are close to that point now.
Who am I kidding? As another hedge fund disappears thanks to mishandling of complex derivatives, I predict that things are going to get even worse.
When it was just a few hundred million dollars here and there that banks were losing we could all have a good laugh at those who had forgotten about convexity or whatever. But now the man in the street has been affected by these fancy financial instruments. It's no longer a laughing matter.
Part of the problem is that many of the people who produce mathematical models and write books know nothing about finance. You can see this in the abstractness of their writing, you can hear it in their voices when they lecture. Sometimes they are incapable of understanding the markets, mathematicians are not exactly famous for their interpersonal skills. And understanding human nature is very important in this business. It s not enough to say ''all these interacting humans lead to Brownian Motion and efficient markets.'' Baloney. Sometimes they don't want to understand the markets; somehow they believe that pure mathematics for its own sake is better than mathematics that can actually be used. Sometimes they don t know they don t understand.
Banks and hedge funds employ mathematicians with no financial-market experience to build models that no one is testing scientifically for use in situations where they were not intended by traders who don t understand them. And people are surprised by the losses!
I realized recently that I've been making a big mistake. I've been too subtle. Whenever I lecture I will talk calmly about where models go wrong and where they can be dangerous. I've said CDO models are bad because of assumptions about correlation. I've pointed out what you can do to improve the models. I've talked about hidden risks in all sorts of instruments and how sensible use of mathematics will unveil them. I've explained why some numerical methods are bad, and what the good methods are. But, yes, I've been too subtle. I now realize that one has to shout to be heard above the noise of finance professors and their theorems. Pointing people in the right direction is not enough. Screaming and shouting is needed.
So here, big and bold, gloves off, in capital letters (for this seems to help), are some fears and predictions for the future.
THERE WILL BE MORE ROQUE TRADERS
While people are compensated as they are, while management look the other way to let the 'talent' do whatever they like, while people mistake luck for ability, there will be people of weak character who take advantage of the system. The bar is currently at £3 billion. There will be many happy to stay under that bar, it gives them some degree of anonymity when things go wrong. But that record will be broken.
GOOD SALESMEN WILL HOODWINK SMART PEOPLE
No matter what you or regulatory bodies or governments do we are all a pushover for the slick salesman.
CONVEXITY WILL BE MISSED
One of the more common reasons for losing money is assuming something to be known when it isn't. Option theory tells us that convexity plus randomness equals value.
CORRELATION PRODUCTS WILL BLOW UP DRAMATICALLY
This means anything with more than one underlying, including CDOs. Stop trading these contracts in quantity this very minute. These contracts are lethal. If you must trade correlation then do it small and with a big margin for error. If you ignore this then I hope you don t hurt anyone but yourself. (I am sometimes asked to do expert-witness work. If you blow up and hurt others, I am very happy to be against you in court.)
RISK MANAGEMENT WILL FAIL
Risk managers have no incentive to limit risk. If the traders don t take risks and make money, the risk managers won t make money.
VOLATILITY WILL INCREASE ENORMOUSLY AT TIMES FOR NO ECONOMIC REASON
Banks and hedge funds are in control of a ridiculous amount of the world s wealth. They also trade irresponsibly large quantities of complex derivatives. They slavishly and unimaginatively copy each other, all holding similar positions. These contracts are then dynamically hedged by buying and selling shares according to mathematical formulae. This can and does exacerbate the volatility of the underlying. So from time to time expect to see wild market fluctuations for no economic reason other than people are blindly obeying some formula.
TOO MUCH MONEY WILL GO INTO TOO FEW PRODUCTS
If you want the biggest house in the neighbourhood, and today not tomorrow, you can only do it by betting OPM (other people s money) big and undiversified. There are no incentives for spreading the money around responsibly.
MORE HEDGE FUNDS WILL COLLAPSE
You can always start a new one. Hell, start two at the same time, one buys, the other sells!
POLITICIANS AND GOVERNMENTS WILL REMAIN COMPLETELY IN THE DARK
Do you want to earn £50k p.a. working for the public sector, or £500k p.a. working for Goldman Sachs? Governments, who are supposed to set the rules, do not even know what the game is. They do not have the slightest clue about what happens in banks and hedge funds. Possibly, for the same reason. London will lose out to New York as a world financial centre.
-  This essay was first published 10 March 2008.