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Models.Behaving.Badly: Difference between revisions
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Given that the motion before the house concerns ''misbehaving'' financial models you might expect some fairly keen insights on this topic: It has already been well documented that [[Black-Scholes]] doesn’t work awfully well when the market is in a state of extreme stress — that is, precisely when you want it working awfully well. In fact, in those situations Black-Scholes can create havoc, and memorably did during the Russian crisis of 1998, during which {{author|Myron Scholes}}’ pioneering hedge fund [[Long Term Capital Management]] catastrophically failed. | Given that the motion before the house concerns ''misbehaving'' financial models you might expect some fairly keen insights on this topic: It has already been well documented that [[Black-Scholes]] doesn’t work awfully well when the market is in a state of extreme stress — that is, precisely when you want it working awfully well. In fact, in those situations Black-Scholes can create havoc, and memorably did during the Russian crisis of 1998, during which {{author|Myron Scholes}}’ pioneering hedge fund [[Long Term Capital Management]] catastrophically failed. | ||
But this | But this isn’t {{author|Emanuel Derman}}'s interest: the specific inadequacy of [[Black-Scholes]] (that it assumes that market events occur in isolation of each other and are therefore arranged according to a "normal" probability distribution) rates barely a mention. Derman’s view is that reliance on *any* financial model will end in tears, simply because models are poor metaphors which are not grounded in the same reality as the sciences whose language they mimic. | ||
Hmm. | Hmm. | ||
{{author|Benoit Mandelbrot}}, whose excellent book {{br|The (Mis)Behaviour of Markets}} clearly outlines the "tail risk" inadequacy of Black Scholes, recognises that it is the market, not the model, that tends to misbehave. A model | {{author|Benoit Mandelbrot}}, whose excellent book {{br|The (Mis)Behaviour of Markets}} clearly outlines the "tail risk" inadequacy of Black Scholes, recognises that it is the market, not the model, that tends to misbehave. A model can’t be blamed for failing to work when misapplied. Guns don’t kill; the people holding them do. | ||
This is a narrow example of a broader principle which (counterintuitively) is true of all scientific theories: they only work within pre-defined conditions in carefully controlled experimental environments. Even Newton's basic laws of mechanics only hold true where there is zero friction, zero gravity, infinite elasticity, infinite regularity and a total vacuum, conditions that in real life never prevail. "Real life" experiments are thus indulged with a margin of error: that a heartily-struck cricket ball does not prescribe precisely the trajectory Newton says it ought is not evidence that his fundamental laws are wrong, but the simply that the pure experimental requirements for its true operation are not present. | This is a narrow example of a broader principle which (counterintuitively) is true of all scientific theories: they only work within pre-defined conditions in carefully controlled experimental environments. Even Newton's basic laws of mechanics only hold true where there is zero friction, zero gravity, infinite elasticity, infinite regularity and a total vacuum, conditions that in real life never prevail. "Real life" experiments are thus indulged with a margin of error: that a heartily-struck cricket ball does not prescribe precisely the trajectory Newton says it ought is not evidence that his fundamental laws are wrong, but the simply that the pure experimental requirements for its true operation are not present. | ||