Models Behaving Badly, Author: Emanuel Derman.
By Noah Smith – Economics, with its focus on human behavior, usually doesn’t do a very good job of explaining financial markets — human behavior, after all, is a very hard thing to model.
The mathematical models of financial engineering, however, are expected to hold with much greater precision. For decades, traders placed trades — big, highly leveraged ones — that market prices would move toward the level implied by derivative pricing models.
Those bets paid off…until they didn’t. Why did financial engineering models fail so disastrously?
Essentially, people had too much confidence in them. more> http://tinyurl.com/ofy7wce
By Steve Denning – In 2005, the chief economist of the International Monetary Fund, Raghuram Rajan, made a speech at Jackson Hole Wyoming in front of an all-star gathering of the world’s most important bankers and financiers, including Alan Greenspan and Larry Summers.
Rajan explained that “because pay was tied to short-term returns, financial managers would want to take so-called ‘tail risks’: risks that almost always paid off with higher returns, but when they went wrong would be catastrophic. That way, most of the time the managers would take home a higher pay packet. If the risk did materialize, they might be fired: a small cost compared to the super-sized bonuses they got while the going was good. Similarly, because these managers’ pay was set relative to their peers, financial managers were incentivized to follow the herd.”
The speech was not well received. more> http://tinyurl.com/nhkbovb