All models are wrong, but some are useful

Notes from interview to Emmanuel Derman by Barry Ritholtz:

  • Born in south Africa
  • Quant finance / models
    • Models for describing business ─ securities: bonds, stocks, etc
  • Transition from particles to human biases within financial markets
    • You set on people
    • All models are wrong, but some are useful
  • How Soros and his reflexivity relates to financial models
    • Some models don’t take reflexivity
    • You have to accept that when building a model, you are short volatility, meaning that if the world changes you may lose
  • Is this because LTCM failed?
    • They were looking for very small deviations
    • They were buying a lot of iliquid assets and leverage like crazy
  • Models behaving badly
    • Models seems to him like analogy
      • Sleep is the interest we have to pay on the capital which is cold in the death, and the more regularly the interest is paid the date of redemption is postponed.
      • You are borrowing your life from darkness and you have to pay it all way back at end.
    • Economists don’t understand the difference between a model and a theory. A metaphor and an accurate description and physicist understand it very well.
  • On the bail out
    • If investors were given a put (the bail out) they should have received a call
  • Quants were useful idiots
    • You were a support not a position holder
  • 1999: GS went public
    • Got more bureaucratic
  • It’s hard to translate an intuition to a number
    • How much pay for an OTM option?
  • How does one should modify a model?
    • In GS, when analyzing derivatives exposures, a model builder was obliged to provide the assumptions and conditions behind the model
    • When having results outside of normal results
  • 1996 wrote an article on model risk
  • Crisis 2007/2008 how much on models?
    • Interest rates were very low and all were stretched for yield
    • Rating agencies helped to the idea of high yield with low risk
  • Finance is like nutrition. People take a small amount of information and extrapolate it like crazy.
  • EMH: it’s not a theory.  Markets are inefficient.   It’s not a true fact.

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