Emanuel Derman

I said I would try to explain what I mean by sophisticated vulgarity in financial modeling, which I will do by imperfect analogy.

Suppose you are thinking of manufacturing tropical fruit salad and you are going to market it in the USA. And suppose there is no tropical fruit salad currently being sold.

Your fruit salad will contain mangos, papayas, passion fruit, coconuts, litchis, kumquats and loquats. Once you quote a price to Whole Foods, your distributor, you will be committed to it, and you need to give them a price. So, you want to figure out how much to plan on charging e for a can of tropical fruit salad which you haven’t actually produced yet. There are a variety of ways you could do it.

1. You could model out how much it would cost to import the raw ingredients –  mangos, papayas, lychees, syrup  and loquats, etc. –from cost at their source, taking account of shipping, shrinkage, insurance, canning, etc, and determine a fair price, allowing for profit. That’s a direct way to proceed, subject to uncertainty about what these costs will be in the future. In that sense it’s a little akin to Black-Scholes modeling of options, which makes assumption about the future that may not/ will not turn out to be true, and then figures out the cost of synthesizing an option.

2. You could build a deeper model, and instead of accepting the market price for the raw mangos, passion fruit, papayas, lychees and loquats  and sugar yourself as a proxy for future fruit prices, you could try to estimate it ab initio, taking into account of the cost of seeds, fertilizer, farmland, your inexperience in raising strange crops, labor etc, and determine the cost that way. That’s deep, but it needs a lot of knowledge you don’t have and will therefore necessarily misestimate. This is a little akin to stochastic volatility models, where you make assumptions about things you really have not much experimental information on. Ambitious, but …

Edward Hadas of the FT/Lex has an interesting video on the debt ceiling fiasco called  Playing Chicken with America’s Future. He calls himself an American Declinist.

Watching Obama and Boehner last night, it’s hard to disagree. I thought Obama was more smoothly manipulative, but not convincingly so,  and Boehner more transparently and crudely manipulative, but neither one was great statesmanship or even statesmanship.

Unfortunately for me, and it may be unfair, no matter what Obama says, I can’t forget the mismatch between what he seemed to promise and what he seems to have done, most particularly with regard to the financial crisis. This cartoon by Barry Blitt  from a Frank Rich op ed in the NY Times almost a year ago is seared in my memory, and dominates my view of Obama.

Near record heat in NYC, 92 degrees even at 9pm.

U.S. govt messed up as usual. Europe too.

The Norway killings.

I was in Norway twice.  The first time was during the LTCM/Russian default crisis, which occurred while I was hiking around the fjords with a group of Norwegians, mostly middle-aged women it turned out. Every day before the start of the hike they played a cassette with the theme song of the Lillehammer Winter Olympics and did three minutes worth of aerobics to it in unison. I grinned the first time, but you should have seen them bound up and down the hills like mountain goats. Especially down, which took more skill. Not only that, but they all loved Bill Clinton. “I like a man who likes women,” one of them said. I went to Norway a second time, about six years later, to Balestrand and Bergen, and it was beautiful. I’d love to go again.

I spent yesterday and today frustratedly trying to communicate to various people at my publisher how get the figures in the proofs of my book corrected, and trying to get a cover design from them. There seems to be a disconnect between the people in charge of the figures and the people in charge of the text, which should coordinate. It reminds me of the disconnect between programmers building the interface to risk systems and people writing the analytics. One person needs to transcend the divide, else things fall in the cracks.

I am trying to see things the publishers’ way, with only a small amount of success. You imagine yours is the only book they’re handling, and in reality you are one of an endless sequence of books that come by their desk on an assembly line. There’s always the same number of books on their horizon; as one book rolls off their assembly line, another rolls on. Maybe I should think of them as a book production factory, with a certain inherent error rate. Then everything would be less surprising.

There is an orgy of glee as people watch the News of the World implode and see powerful or formerly powerful people threatened with legal action and loss of power.  It’s a nice distraction in which almost everyone can feel righteous. There was a similar frenzy when FNMA, FHLMC and Lehman collapsed, but with no consequent long term behavioral consequences. One of the questions I don’t know the answer to, but which keeps presenting itself to me these days, is:

How do you restrain or punish corporations, collections of people that have some of the advantages of real people, but less of the disadvantages?

Larry Summers writes that “The European Central Bank is right that punishing creditors for the sake of teaching lessons or building political support is reckless in a system that depends on confidence.” This an argument against punishment, for our own greater good.

You’d think physicists would see everything in material terms, but it’s biologists and neuroscientists who are the new materialists …

That is the beginning of a short note I wrote for Wired.UK a few months ago, that continues HERE in their August issue.

The world is complex and you lose a lot by insisting things you don’t understand already fit into the boxes you imagine you do.

There is an article on Bloomberg about the salaries earned by risk managers, here.

Here are brief summaries I found on the web of the backgrounds of the people involved:

Mr. Thompson holds an MBA from the Darden School at University of Virginia, where he graduated with honors, and a bachelor’s degree from Allegheny College, where he also graduated with honors and was elected to Phi Beta Kappa. Zubrow worked at Goldman Sachs from 1979 to 2004, JPMorgan said. His last job before leaving the firm where Corzine was co- chairman until 1999 was chief administrative officer. Brian  (Leach) has a B.A. in economics from Brown University and an M.B.A. from Harvard Business School.

What I conclude from this is that these are not traditional risk people now making a lot of money. These are traditional make-a-lot-of-money people now doing risk.

What’s Your Edge?
If you are going to seek a career in quantitative finance, what’s your advantage? Is it computer science, financial theorizing, pragmatic modeling, sales or trading, working on the desk with people or solitarily in an office? Which are you best at and, also, which do you enjoy doing most?

For years I came across people who could have had wonderful careers combining finance and applied computer science, a combination rarely found in investment banks, and yet so few of them want to take advantage of their computer skills.

Collegial or Solitary?
What environment do you like working in? Academic or  bureaucratic? Do you like being supervised and taught or do you want to go your own way? Do you want to work in a large organization or a small one? This can make the difference between choosing an investment bank, a hedge fund, or a financial software company.

The other day the new MSFE students showed up at Columbia for orientation and I had to welcome them. These are some notes from what I said.

Part 1

Background
Several years ago, my son, who did a PhD thesis on the reception history of Max Weber, the founding father of sociology, introduced me to two influential essays by Weber, entitled respectively Science as a Vocation and Politics as a Vocation. In them Weber discusses what problems you have to face, and what personality and character you have to own, if you decide to make these fields your calling, and he’s surprisingly thoughtful and yet practical about it.I thought it would be interesting to begin to think about the same questions with respect to entering the field of Quantitative Finance, particularly from a practitioner’s point of view.

Financial “Engineering“?!
According to Zvi Bodie, financial engineering is the application of science-based mathematical  models to decisions about saving, investing, borrowing, lending, and  managing risk. I think that’s a reasonable definition.

Last night I went to see Terrence Malick’s “The Tree of Life.” It’s not a movie, it’s a multiverse, a meditation, a “Koyanisqaatsi” inspired by the Bible rather than by Buddhist texts.

Who the hell are you to question what I do? God said to the people who thought he had punished Job for his (Job’s) bad deeds. It’s about the wonder and the horror, the good and the bad that all exist beyond explanation.

God’s existence, according to one part of the movie, is evident just as much in his turning away from you as in his paying attention to you. It ends in a scene reminiscent of the end of “The White Hotel” (a marvelous book) by D.M. Thomas, with everyone from the past, present and future brought together. If you have religious inclinations, it’s a multidimensional story and meditation on Job and time and connectedness and mysterious fate. If you don’t, it’s the same, and you can still be be entranced by its pantheistic vision, but the background music may irritate you.

Many articles lately about protecting your portfolio against “tail risk.”

Tail risk, unfortunately, is not one thing.

Death can be caused by many illnesses. To protect yourself against death successfully for an extended period you may need vaccination against many viruses and a variety of antibiotics against germs. Worse, some of the treatments may be hazardous to your health; many diseases are in fact iatrogenic, caused by the doctors and medicines intended to cure the patient. There is no panacea.

Analogously, the value of a portfolio can be substantially destroyed by more than one cause. Portfolios can be ruined by equity crashes, credit spread widenings, bond defaults, high interest rates, sustained inflation, increases in volatility, illiquidity, etc. To protect your portfolio against so-called tail risk may require spending money on insurance against all these risks, and there is no panacea here either.