http://www.wilmott.com/blogs/paul/index.cfm/2008/3/10/This-is-No-Longer-Funny Iâve been critical of much of quant modelling for many years. I donât like the assumptions, the models, the implementations. Iâve backed this up with sound reasons and wherever possible tried to find alternative approaches that I think are better. I donât 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 the those who had forgotten about convexity or whatever. But now the man in the street has been affected by these fancy financial instruments. Itâs 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. Itâs not enough to say âall these interacting humans lead to Brownian Motion and efficient markets.â Baloney. Sometimes they donât 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 donât know they donât 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 donât understand them. And people are surprised by the losses! I realized recently that Iâve been making a big mistake. Iâve been too subtle. Whenever I lecture I will talk calmly about where models go wrong and where they can be dangerous. Iâve said CDO models are bad because of assumptions about correlation. Iâve pointed out what you can do to improve the models. Iâve talked about hidden risks in all sorts of instruments and how sensible use of mathematics will unveil them. Iâve explained why some numerical methods are bad, and what the good methods are. But, yes, Iâve been too subtle. I now realise 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 ROGUE TRADERS: While people are compensated as they are, while management look the other way to let the âtalentâ 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 â¬5billion. 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 isnât. 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 donât 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 donât take risks and make money, the risk managers wonât 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 worldâs 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 peopleâs 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.
i basically agree with you on people having been too optimistic on the preciseness of their methods, i think you are overshooting. CDOs as such are valid because they are nothing but a fund with a structured passive side of the balance sheet. modelling this structure is like modelling the active side of a fund by means of VaR: just because VaR sometimes gets into multiple sigma events you do not throw the method as such out of the window. so, modelling CDOs is okay as CDOs as such are okay. very different animal are all these bespoke curve fits. a bespoke, synth CDO coming out of an optimising machine is the ultimate, completely useless curvefit. managed CDOs (though more expensive investments than hedge funds!) are valid. the real problem was the sales effort that brought too many people into a game they did not understand. this includes the sellers. at many desks people where just too young to ever have seen a crisis. and of course the buyers. just because you can choose a portfolio does not man you are really able to ... implied correlation is a very dangerous phrase because it profits from the similar term implied volatility, which is a much more meaningful term. we suggested to one of our clients two years ago to use implied default rate to value tranches, since here you have at least historics to compare to.