How to Understand the Limits of Financial Models

• Published in: Institutional Investor 2011-10
• Main Author: Derman, Emanuel
• Format: Article
• Language: English
• Subjects: Capitalism; Economic models; Economic theory; Economists; Interest rates; Investment banking; Mathematics; Physics; Privatization; Securities analysis
• ISSN: 0020-3580

Few people understand the rise of quantitative financial techniques, and their limits, as well as Emanuel Derman does. The crisis has been marked by the failure of models both qualitative and quantitative. Financial modeling is not the physics of markets. The similarity of physics and finance lies more in their syntax than in their semantics. Unfortunately, financial models are only models, not reality or even close to it. Economists for the most part have never seen a genuinely successful theory. The simple models they work with fail to reflect the complex reality of the world around them. That lack of success is not the fault of economists, for people, unlike matter, are difficult to theorize about. But it is the economists' fault that they take their simple models so seriously. Capitalism's problems will not be solved by models. But just as certainly, financial models are not going to disappear. Given the inevitable unreliability of models and the limited truth or likely falseness of the assumptions they're based on, the best strategy is to use them sparingly and to make as few assumptions as possible when you do.