Today, we talk about the differences between models & theories, finance & physics, and life & experiments. We look under the hood of the Black-Scholes[-Merton] option pricing formula, talk about the gaps in classical and behavioral financial models, and find out what he would change about his life if he could live it again.
On twitter: @EmanuelDerman
Books: My Life as a Quant, Models.Behaving.Badly
[0.47] Intro. Models & Theories.
[3.45] What differentiates a theory or model in physics from one in finance?
[5.43] How to protect yourself from self-deception.
[6.55]William Blake "If a fool were to persist in his folly, he would become wise."
[7.26] At Goldman, they used models without idolizing them.
[8.40] What do you teach your students at the Columbia Financial Engineering Program?
[10.15] Example: Black-Scholes[-Merton] model for option pricing. Andy Lowes at MIT, "In physics, you have three laws that explain 99% of phenomena. In finance, you have 99 laws that explain 3% of phenomena."
[12.15] Principle of replication (arbitrage pricing theory).
[16.20] What you need to know to price a derivative. How does it fail? Correcting for that. Paul Wilmott.
[22.02] Physics: better to go deep (abstract principles). Finance: sometimes better to stay on the surface. Eugene Fama: "Finance is what doesn't go away after everyone knows about it." Elon Musk: importance of thinking by first principles vs. thinking by analogy.
[24.50] ED's favorite models. Black-Derman-Toy for interest rate. Local volatility model. Extensions of option pricing. Fixing and extending models by relaxing perfect/Platonic assumptions. Mao Tse-tung: "Let a thousand flowers bloom."
[27.07] Nassim Taleb's critiques of financial modeling. Heuristics.
[29.30] Using the process of model-building to help discipline your thoughts. Quantifying vague intuitions.
[31.50] Institutional problems. Understanding the underlying assumptions.
[33.17] Exciting areas in finance research. Moving from derivatives to the underlying assets. Market microstructure.
[36.00] Behavioral finance. (I'm a bigger fan of finding better psychological bases to economic behavior and economic concepts like risk or utility, rather than disguising social psychology research as economics through the use of math. That's what I'm babbling about in this section. -SG). Subjectivity in economic models: it's actually "How much money do I stand to gain or lose
Hayek: In physics, the macroscopic things are sense data and real...and atoms are the abstractions. In finance, the only things that are real are the people, the markets are the abstractions. Mel Brooks on comedy vs. tragedy.
[44.24] Recommended reading: Justin Fox The Myth of the Rational Market, John Kay Other People's Money, Emanuel Derman Models.Behaving.Badly, Nassim Taleb's Black Swan & Antifragile, Elie Ayache The Blank Swan & The Medium of Contingency.
[48.48] Manfred Eigen
[49.12] More about Emanuel Derman can be found at..., What he would like to do if he could relive his life over again, How you can respond to a model vs. a theory.
Monte Carlo method
Efficient Market Hypothesis
Geometric Brownian motion (random walk, martingale)
Jump diffusion models
Black-Derman-Toy interest rate model
Derman-Kani trees/ volatility smile models