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Models. Behaving. Badly: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life


Praise for Models.Behaving.Badly.

"Emanuel Derman has written my kind of book, an elegant combination of memoir, confession, essay on ethics, philosophy of science, and professional practice. He convincingly establishes the difference between model and theory and shows why attempts to model financial markets can never be genuinely scientific. It vindicates those of us who hold that financial modeling is neither practical nor scientific. Exceedingly readable."
NASSIM N. TALEB, author of The Black Swan

"This is a compelling, accessible, and provocative piece of work that forces us to question many of our assumptions. As Derman explains so clearly, models are not 'bad' in themselves; on the contrary, they are crucial for modern society. However, they have been used in a dangerously sloppy and careless way, with sometimes terrible results. Derman explains this clearly and draws heavily on his own lifetime experience—ranging from growing up in apartheid South Africa to working in the scientific field and then as a financial engineer on Wall Street—to provide a moving and fascinating set of illustrations of these principles. The conclusion is unexpectedly optimistic—if people choose to listen."
GILLIAN TETT, author of Fool's Gold

"An engaging and personal meditation on the limitations of our ability to predict the future, especially—but not only—in the context of financial markets. He is not interested in blame or politics, but in the deeper lessons to be drawn from the financial crisis. As a physicist who was also highly placed in the financial world, he explains clearly the difference between prediction and advice, theory and model, and knowledge and wisdom."
LEE SMOLIN, senior researcher at Perimeter Institute for Theoretical Physics; author of The Trouble with Physics, The Life of the Cosmos, and Three Roads to Quantum Gravity

"If you don't want your models to behave badly, you should study carefully these words of wisdom on the philosophy of quantitative modeling. Emanuel Derman has always been one of the most respected quants on Wall Street. Now he has proven that he is also one of the most thoughtful. Though in the sequel he should tell us what happened to the large man over the Sudan!”
CLIFFORD S. ASNESS, PhD, managing and founding principal, AQR Capital Management

EMANUEL DERMAN is Head of Risk at Prisma Capital Partners and a professor at Columbia University, where he directs their program in financial engineering. He is the author of My Life As A Quant, one of Business Week's top ten books of the year, in which he introduced the quant world to a wide audience.
He was born in South Africa but has lived most of his professional life in Manhattan in New York City, where he has made contributions to several fields. He started out as a theoretical physicist, doing research on unified theories of elementary particle interactions. At AT&T Bell Laboratories in the 1980s he developed programming languages for business modeling. From 1985 to 2002 he worked on Wall Street, running quantitative strategies research groups in fixed income, equities and risk management, and was appointed a managing director at Goldman Sachs & Co. in 1997. The financial models he developed there, the Black-Derman-Toy interest rate model and the Derman-Kani local volatility model, have become widely used industry standards.
In his 1996 article Model Risk Derman pointed out the dangers that inevitably accompany the use of models, a theme he developed in My Life as a Quant. Among his many awards and honors, he was named the SunGard/IAFE Financial Engineer of the Year in 2000. He has a PhD in theoretical physics from Columbia University and is the author of numerous articles in elementary particle physics, computer science, and finance.

1. A Foolish Consistency 3

2. Metaphors, Models, and Theories 33


3. The Absolute 73

4. The Sublime 107


5. The Inadequate 139

6. Breaking the Cycle 189

Appendix: Escaping Bondage 201

Acknowledgments 205

Notes 207

Index 217