http://www.wilmott.com/blogs/jandash/index.cfm en-us Sun, 26 May 2013 08:21:01 --0100 Mon, 03 Jan 2011 10:48:00 --0100 BlogCFC http://blogs.law.harvard.edu/tech/rss blogs@wilmott.com blogs@wilmott.com http://www.wilmott.com/blogs/jandash/index.cfm/2011/1/3/The-2010-Climate-BS-Of-The-Year-Award This is the press release for "The 2010 Climate B.S.* Of The Year Award". I was a signatory to the text, the full version of which is attached. By: Pacific Institute OAKLAND, Calif. Dec. 30, 2010 - Today marks the release of the very first Annual Climate B.S.* of the Year Award. While many observers think they know what "B.S." means, here the award is presented for the "Bad Science" of the Year. The Award is being simultaneously released on a number of climate sites, among them: Skeptical Science, deSmogBlog, UU-UNO Climate Portal, Conservation Minnesota, The Cost of Energy Blog, ScholarsandRogues.com; Huffington Post, SF Gate "City Brights," Pacific Institute, and more. 2010 saw widespread and growing evidence of rapidly warming global climate and strengthening scientific understanding of how humans are contributing to climate change. Yet on the policy front, little happened to stem the growing emissions of greenhouse gases or to help societies prepare for increasingly severe negative climate impacts, including now unavoidable changes in temperature, rainfall patterns, sea-level rise, snowpack, glacial extent, Arctic sea ice, and more. These physical impacts will lead to sharply increased disease, military and economic instabilities, food and water shortages, and extreme weather events, among other things. Without appropriate risk management action, the United States will be hit hard. Yet confusion and uncertainty about climate change remain high in the minds of too many members of the public and Congress. Why? In large part because of a concerted, coordinated, aggressive campaign by a small group of well-funded climate change deniers and contrarians focused on intentionally misleading the public and policymakers with bad science about climate change. Much of this effort is based on intentional falsehoods, misrepresentations, inflated uncertainties, and pure and utter B.S. about climate science. These efforts have been successful in sowing confusion and delaying action ? just as the same tactics were successful in delaying efforts to tackle tobacco's health risks. In response, a group of climate scientists, climate communicators, and other experts solicited nominations for Climate B.S* of the Year from around the world and then narrowed the list down to five finalists. Voting produced the following award winners: Fifth Place. Climate B.S. and misrepresentations presented by Fox "News." Fourth Place. Misleading or false testimony to Congress and policymakers about climate change. Third Place. The false claim that a single weather event, such as a huge snowstorm in Washington, D.C., proves there is no global warming. Second Place. The false claim that the "Climategate" emails meant that global warming was a hoax, or was criminal. In fact, it was none of these things. AND THE WINNER OF THE 2010 CLIMATE B.S.* OF THE YEAR AWARD? First Place. "There has been no warming since 1998" [or 2000, or?], "the earth is cooling," "global warming is natural," and "humans are too insignificant to affect the climate." All of these claims are false according to climate science. The award goes to all those climate change deniers who promulgate these false claims in the media, before Congress and the public, and throughout the blogosphere: such statements are all nonsense and long refuted by real climate science. For full details on each prize winner's contribution to climate B.S., visit one of the posting sites. Dr. Peter Gleick, one of the co-authors and creators of the Award, a member of the U.S. National Academy of Science, and a hydroclimatologist by training, said: "The public and our policymakers are being bombarded with climate B.S. It is long past time this B.S. was called out for what it is: bad science. Policymakers should not hide behind bad climate science as an excuse to avoid taking actions now to both reduce greenhouse gas emissions and prepare for inevitable climate impacts." [* B.S. ? "Bad Science"] Website: www.pacinst.org ---------------- Global Warming Mon, 03 Jan 2011 10:48:00 --0100 http://www.wilmott.com/blogs/jandash/index.cfm/2011/1/3/The-2010-Climate-BS-Of-The-Year-Award http://www.wilmott.com/blogs/jandash/index.cfm/2010/7/12/Free-Opera-in-Central-Park-July-14-and-Aug-18--NY-Grand-Opera-2010 The Rain God is hitting opera hard. Both outdoor summer performances of the NY Grand Opera unfortunately had to be postponed because of inclement weather. Verdi's opera ?Giovanna d'Arco? is rescheduled for October 21, 7:30pm at the CHURCH OF ST. PAUL AND ST. ANDREW, WEST 86TH STREET AT WEST END AVENUE. Free admission. The NY Grand Opera performance of Puccini?s ?Madama Butterfly? Wed. August 18 has also been postponed because of predicted inclement weather. NY Grand Opera information: Maestro Vincent La Selva conducts. Full productions - soloists, chorus, full orchestra, staging. Get there early for a good seat. You might want to consider bringing a folding chair. The reserved seats in front are for the Guild (which of course you could join). Admission is FREE. Location: Naumburg Bandshell, Central Park (72 St. near 5th Ave). Details: http://www.newyorkgrandopera.org/ ------------------------ Music Mon, 12 Jul 2010 20:34:00 --0100 http://www.wilmott.com/blogs/jandash/index.cfm/2010/7/12/Free-Opera-in-Central-Park-July-14-and-Aug-18--NY-Grand-Opera-2010 http://www.wilmott.com/blogs/jandash/index.cfm/2010/6/30/Corrections-to-book-3rd-printing The attached file has some corrections to the 3rd printing of my book, discovered while teaching a course from it last fall at the Courant Institute NYU. Book Wed, 30 Jun 2010 13:35:00 --0100 http://www.wilmott.com/blogs/jandash/index.cfm/2010/6/30/Corrections-to-book-3rd-printing http://www.wilmott.com/blogs/jandash/index.cfm/2010/1/30/Climate-Change-and-Global-Warming-talk You may be interested in my recent talk on Climate Change and Global Warming, posted on the UU-UNO climate portal: http://www.trunity.net/uuuno/articles/view/143772/?topic=23692 The talk presents a summary of climate science, global warming impacts, mitigation strategies, climate politics, carbon finance, and contrarians. The Copenhagen climate conference (Dec 09), which I attended, is discussed. The UU-UNO climate portal contains educational climate material, links, and RSS feeds automatically posting current climate information. Check it out. --------------- Global Warming Sat, 30 Jan 2010 12:29:00 --0100 http://www.wilmott.com/blogs/jandash/index.cfm/2010/1/30/Climate-Change-and-Global-Warming-talk http://www.wilmott.com/blogs/jandash/index.cfm/2009/11/17/Climate-Change-paper-Committee-on-Sustainable-Development-NY-CoNGO-UN This is the cover letter for a recent paper "Climate Change: Summary and Recommendations to Governments" by the CoNGO Committee on Sustainable Development (New York). CoNGO is the Conference of Non-governmental Organizations in Consultative Relationship with the United Nations. The paper is attached as a pdf file. "Environmental, social and economic development that meets the needs of the present without compromising the ability of future generations to meet their own needs." 17 November 2009 Dear NGO Leader, The CoNGO Committee for Sustainable Development is pleased to present the attached Climate Change Paper, containing recommendations to Governments on four critical issues: (1) the dangers of unmitigated climate change impacts; (2) reaching accord on climate change at COP15; (3) risk-management mitigation and adaptation strategies; and (4) assistance to developing countries. The Committee urges your NGO to encourage all nations to act clearly and decisively on these issues, as equitable, humane, ethical, and beneficial solutions are possible. Let not future generations say, of us: ?They knew, but did not act?. Please add the voice of your NGO to this message by signing on to this paper with an email to: climatechangepaper@gmail.com Thank you. Sincerely, Ann Braudis Co-Chair, Maryknoll Sisters of St. Dominic, Inc. Iryna Kurowyckyj Co-Chair, International Council of Women Lily Schwabe Secretary, Temple of Understanding Aaron Etra Treasurer, B?nai B?rith Jan Dash Member at Large, Unitarian Universalist UN Office Brad Jenkins Member at Large, Rotary International Nana-Fosu Randall Member at Large, Voices of African Mothers Larry Roeder Member at Large, World Society for the Protection of Animals Patricia Scharlin Member at Large, World Association of Girl Guides and Girl Scouts ------------ Global Warming Tue, 17 Nov 2009 18:46:00 --0100 http://www.wilmott.com/blogs/jandash/index.cfm/2009/11/17/Climate-Change-paper-Committee-on-Sustainable-Development-NY-CoNGO-UN http://www.wilmott.com/blogs/jandash/index.cfm/2009/10/22/New-UUUNO-Climate-Change-Web-Portal You are invited to visit the new UU-UNO Climate Change web portal at http://www.trunity.net/uuuno/. The focus is on resources covering the science, impacts, and mitigation of climate change / global warming, including informative RSS feeds. Ethical and moral aspects of action are discussed. There will be coverage of the Copenhagen COP15 conference in December. © 2009 Jan W. Dash. All rights reserved. ---------- Global Warming Thu, 22 Oct 2009 23:07:00 --0100 http://www.wilmott.com/blogs/jandash/index.cfm/2009/10/22/New-UUUNO-Climate-Change-Web-Portal http://www.wilmott.com/blogs/jandash/index.cfm/2009/7/14/Trovatore-and-Butterfly The New York Grand Opera will perform the complete Verdi opera ?Il Trovatore? on Wed. July 15 at 7:30 PM, at the Naumburg Bandshell in Central Park on 72 St. near 5th Ave. Puccini?s ?Madama Butterfly? will be performed on Wed. August 12 at 7:30 PM. Maestro Vincent La Selva conducts. This is the full production - soloists, chorus and full orchestra, with staging. I am the NYGO Chorus Master, and will be the Old Gypsy in Trovatore, plus the Drunk Uncle in Butterfly. Get there early. You might want to consider bringing a folding chair - the reserved seats up front are for the Guild (which of course you could join). Admission is free. Details as usual are at: http://www.newyorkgrandopera.org/ ------------------------ Edit after the Trovatore performance. We had beautiful weather and a good crowd for Trovatore. The curtain call is pasted above. Maestro La Selva is in the white tux jacket. I am far left / stage right. More: The Old Gypsy: http://images.solvaraphotography.com/gallery/8938415_qVfs7#593609174_ydVac NY Times review: http://www.nytimes.com/2009/07/17/arts/music/17opera.html EDIT: The Madama Butterfly performance Wed 8/12/09 has unfortunately been CANCELED due to predicted rain. It will be rescheduled at some future date. © 2009 Jan W. Dash. All rights reserved. Music Tue, 14 Jul 2009 14:50:00 --0100 http://www.wilmott.com/blogs/jandash/index.cfm/2009/7/14/Trovatore-and-Butterfly http://www.wilmott.com/blogs/jandash/index.cfm/2009/5/21/EPA-Hearing-on-Greenhouse-Gases I went down to Arlington VA on Monday (May 18) to give some testimony for the EPA, officially the ?U.S. Environmental Protection Agency's Public Hearing on the Proposed Endangerment and Cause or Contribute Findings for Greenhouse Gases under the Clean Air Act?. The time was limited to four minutes for each speaker. My contribution is attached as a pdf file. It is directed towards impacts to the US because the EPA is a US agency. Although the talks I heard were mostly reasonable, I did hear one contrarian who ineffectively blustered away at the science with some of the usual irrelevant fallacies. For those interested in exploring the myriad fallacies pushed by contrarians, an excellent source is the website run by climate scientists, realclimate.org The official transcript is under docket EPA-HQ-OAR-2009-0171 at http://www.regulations.gov/fdmspublic/component/main?main=DocumentDetail&o=09000064809d1901 © 2009 Jan W. Dash. All rights reserved. ---------- Global Warming Thu, 21 May 2009 22:02:00 --0100 http://www.wilmott.com/blogs/jandash/index.cfm/2009/5/21/EPA-Hearing-on-Greenhouse-Gases http://www.wilmott.com/blogs/jandash/index.cfm/2009/4/25/Faust-Economics-Psychology-and-Models It has now become clear that a ?Faustian bargain? made by finance academics has broken down. What bargain? The bargain was the adoption of the holy dictum of ?no arbitrage? for financial modeling, which meant the finance department didn?t have to understand or cope with economics. Ditto for psychology. However, traders and investors are acutely aware of economics and psychology. Questions: Is there some sort of disconnect? Are we paying the price? Answer to both questions: Yes. I propose that we review this Faustian bargain. Here are the basics for financial models. No financial model has the status of a physical law (regardless of who is pushing the model, regardless of whatever mathematical framework is being used, regardless of how sophisticated it is, and regardless of whether fat tails are in it or not). Any financial model is really only a phenomenological construct. The parameters that are needed to specify the model are ?implied?. In practice this means that a model, intended to price some security, first prices other securities or quantities in accord with market prices. Other parameters are determined by fits to historical data, and/or using ?fundamentals?. But this procedure, which the finance industry has used since the beginning of the ?Quant Age? in the 1980?s, has now broken down for many securities. Models that are constructed using the best information, using the best attempts at consistency, and using conservative assumptions on the fundamentals, cannot describe the insanely low market prices for many securities. This is a huge problem. It cannot be said too strongly ? the implied parameter approach used to specify model parameters is now dysfunctional in some markets. Whose fault is this? Does the fault lie with the Faustian bargain? Let?s start with economics. It is clear now that market prices do reflect economics ? e.g. the recession. For example, long-term debt clearly has a component that is ruled by economics (and not just default). Spreads for bonds are now so high that they imply unbelievable default rates. The Fed stress tests are macro-economically driven. So why aren?t economic variables found in models for bonds? Answer: The Faustian bargain. Actually, there is at least one model that started to address the issue of economics and financial modeling, the ?Macro-Micro? model. Also, factor models provide a framework for including many variables. I believe such models should be taken more seriously and made more explicit. This is a daunting challenge, but I believe we can no longer avoid it. We need to get away from the Faustian bargain. What about psychology? Market prices are now at least partially ruled by psychology, involving e.g. fear and damage control. The so-called ?investor rationality? has disappeared (actually this statement is just a tautology that re-expresses the breakdown of the financial axioms; investors individually under the circumstances are actually being very rational). Psychology has always been instrumental in the markets, but now psychology has broken the markets. However, we have no ?psychology? parameters in models. Is this a fundamental error? Yes, I think so. Can we get away from the Faustian bargain here? I don?t know. It is a humbling experience. In this space of fog, there is at least one clear point. Can?t we just blame the quants? Here the answer is clear: ?Nope?. Quants just implement the general religious dictum provided by the academics (naturally with bells and whistles). For the record, the recent catastrophic mortgage meltdown is not the first time quants have been blamed. I remember an incident once reported to me where a particularly obnoxious mortgage trader got up in front of a group meeting and demanded that the head quant apologize for his model, which the trader accused of causing mortgage-trading losses! Ugh. What does the future hold? The banks have argued that we cannot mark-to-market for securities if there is no market for those securities. They certainly have a point. So they argue that we should mark-to-model. Uh-oh. No more constraints on the models from the market? What is going to constrain the models now? Certainly not ?model validation?, which doesn?t address the fundamental problem - as I said no model is ?valid? in the sense of physics. What about ?parameter reasonableness? criteria? The answer would be ?Yes? for some parameters, but ?No? for other parameters that depend on the broken model vs. market consistency. We are in uncharted waters. I can foresee the emergence of two classes of models: #1 for traders that need to trade on the market, and #2 for capital determination and regulatory reporting. Confusion will reign. Now by no means do I want to imply that models are useless. We need models. Nor do I want to imply that we abandon implied parameters. We want to have models that describe market prices, if possible. But current models may be too narrowly focused. At least with present horrible market conditions, and maybe in general, I believe that we need, somehow, to include economics and psychological constructs in the models. Maybe someday with a return of confidence, the blue skies will re-emerge, investors will again become ?rational?, and the current models relying on the Faustian bargain will again have reasonable implied parameters that do describe the traded market prices. And maybe not. In any case, we should keep in mind that even if the good times return, the entire financial system could well exhibit systemic fragility again ? that is, it could break again. Faust was a winner for a long time. However, Faust had his problems. Where did he wind up? For the quant modelers reading this, I recommend that for background you get a CD or DVD of the opera ?La Damnation de Faust? by Berlioz, and listen closely. Then shut off the CD player, go to your local University, look up a friendly Economics professor, and then find out where the Psychology Department is located. That?s where I?m headed. ------------ Refs: 1. Fed SCAP stress tests: http://online.wsj.com/public/resources/documents/scap2009424.pdf 2. Market vs. Model: Andrew Davidson Industry Insight - Proposed FSP FAS 157-e: http://www.riskcenter.com/story.php?id=18201 3. Bond spreads and defaults: http://online.wsj.com/article/SB123803103548043611.html#mod=loomia?loomia_si=t0:a16:g12:r2:c0.25105:b23576652 4. Macro-Micro Model: Chapters 47 ? 52, my book: http://books.global-investor.com/books/19880.htm?ginPtrCode=10202 5. Faust: http://en.wikipedia.org/wiki/Faust ---------- © 2009 Jan W. Dash. All rights reserved. Quant Finance Sat, 25 Apr 2009 14:43:00 --0100 http://www.wilmott.com/blogs/jandash/index.cfm/2009/4/25/Faust-Economics-Psychology-and-Models http://www.wilmott.com/blogs/jandash/index.cfm/2009/1/19/Mitchell-Lurie-clarinetist Mitchell Lurie was one of the premier clarinetists of the 20th century. His career is outlined in his obituaries in the Los Angeles Times and the Guardian. I took clarinet lessons from him long ago, and he played a pivotal role in my life. He suggested that I should apply to the Curtis Institute of Music, but then when I said that I was undecided between science and music, he advised me to go into science and play music on the side. So I followed his advice. He was demanding, while being so encouraging and inspirational as a teacher. He made you feel that you could play anything. Mitchell was honored at the ICA Clarinet Fest in Atlanta in 2006, but could not attend because of ill health. Afterwards I delayed calling him, and now it is too late. So I am writing this in memory. Rest in peace, Mitchell. Jan http://www.latimes.com/news/obituaries/la-me-lurie30-2008nov30,0,263373.story?page=1 http://www.guardian.co.uk/music/2009/feb/10/obituary-mitchell-lurie http://www.clarinet.org/pdfs/fests/2006/CFest_2006_Detailed_Schedule.pdf ----------- Music Mon, 19 Jan 2009 02:49:00 --0100 http://www.wilmott.com/blogs/jandash/index.cfm/2009/1/19/Mitchell-Lurie-clarinetist http://www.wilmott.com/blogs/jandash/index.cfm/2009/1/10/Models-Phenomenology-and-All-That There is a profound misunderstanding by some people of the fundamental nature of models, and more generally of quantitative finance and risk management, from accountants to professors to players in the world of finance to the general public. A better analysis and attribution of some causes of the current financial crisis ? and perhaps helping to prevent future such crises - would be obtained by a better understanding of what financial models really are. Emanuel Derman and Paul Wilmott have a good Manifesto, to which I subscribe and effective already pre-signed in my book. Below are some quotes from the book (ref) that indicate my Philosophy of Models, the basic lines of which I have preached ever since coming to the Street in the late 80?s, and written long before the current crisis. The bottom line is that, in spite of the fact that Models, Quantitative Finance, and Risk Management may resemble ?hard science?, and while we should and do try to be as scientific as possible, the real deal is that what we have always had is what physicists call ?phenomenology?. This does not mean that the models are useless. We always need qualitative judgment, but we also need models. What does all this mean? What are some implications? Read on for some thoughts. Ref: Excerpts from Quantitative Finance and Risk Management, A Physicist?s Approach: Pp. 7-8 (Ch.2); Pp. 415-420 (Ch. 32); Pp. 421-424 (Ch. 33); footnote 9, page 508 (Ch. 42). ? Why is Quantitative Finance not a Science? In science there is real theory in the sense of Newton's laws (F = ma) backed by a large collection of experiments with high practical predictive power and known domains of applicability (for Newton?s laws, this means objects not too small and not moving too fast). In contrast, financial theoretical "postulates", when examined closely, turn out to involve assumptions, which are at best only partially justifiable in the real world. The financial analogs to scientific "experiments" obtained by looking at the market are of limited value. Market information may be quite good, in which case not much theory is needed. If the market information is not very good, the finance theory is relatively unconstrained. Finance computer systems are always incomplete and behind schedule (this is a theorem). . Quantitative Finance is Not Science but Phenomenology The situation characterizing quantitative finance is really what physicists call "phenomenology". Even if we could know the "Newton laws of finance", the real world of finance is so complex that the consequences of these laws could not be evaluated with any precision. Instead, there are financial models and statistical arguments that are only partially constrained by the real world, and with unknown domains of applicability, except that they often break when the market conditions change in an extreme fashion. The main reason for this fragility is that human psychology and macroeconomics are fundamentally involved. The worst cases for risk management, such as the onset of collective panic or the potential consequences of a deep recession, are impossible to quantify uniquely?extra assumptions tempered by judgment must be made. . What About Uncertainties in the Risk Itself? A characteristic showing why risk management is not science deals with the lack of quantification of the uncertainties in risk calculations and estimates. Uncertainty or error analysis is always done in scientific experiments. It is preferable to call this activity "uncertainty" analysis because "error" tends to conjure up human error. While human error should not be underestimated, the main problem in finance often lies with uncertainties and incompleteness in the models and/or the data. Risk measurement is standard, but the uncertainty in the risk itself is usually ignored. In finance, there is too often an unscientific accounting-type mentality. Some people do not understand why uncertainties should exist at all, tend to become ill tempered when confronted with them, and only reluctantly accept their existence. The situation is made worse by the meaningless precision often used by risk managers and quants to quote risk results. Quantities that may have uncertainties of a factor of two are quoted to many decimal places. False confidence, misuse and misunderstanding can and does occur. A fruitless activity is attempting to explain why one result is different from another result under somewhat different circumstances, when the numerical uncertainties in all these results are unknown and potentially greater than the differences being examined. . Summary of Model Risk We start with the obvious comment that models are now an indispensable part of modern finance. Securities and derivatives require model pricing. Therefore, models are indeed indispensable. Finance could not live without them. Nonetheless, in spite of the best efforts of many talented and smart people, model risk is constantly present at some level and is due to many causes. One risk is the variability in model assumptions, none of which can be proved in any rigorous way . Some important effects on prices can be modeled only imperfectly, if at all. No financial model has the status of a ?law of physics?, even if physics-based diffusion models and other concepts are used. Further, there is no ?best? model, regardless of whose ego is involved. Different firms can and do have different models for the same instrument. Model risk is hidden unless model-to-model or model-to-market comparisons are made. The risk is highest for illiquid, long-dated options. For highly liquid instruments, models are standardized with slight variations. Substantial losses due to model risk have occurred even for plain-vanilla products, however . Model risk includes the risk of using approximate or inappropriate parameter types, or using the model in inappropriate parameter regimes. Models are used in practice to parameterize securities in some approximate way, and are usually only to be trusted for some short extrapolation from the region where market data are available. These parameters include maturity length, strike values for options, etc. The intentional use of inaccurate parameter values is a separate problem . Numerical approximations are unavoidable and are a function of available time and resources, but they can lead to difficulties. Part of model risk lies in the pitfalls of software development. See Ch. 34. A host of mundane but important issues exists: coding errors, computer malfunctions, misinterpretations, communication snafus, inconsistencies, etc. Anyone who wants to get an idea of the difficulty is invited to sit down at the computer and give it a try . Model-generated hedging predictions are more problematic than pricing, since hedging involves taking differences of prices under changing market conditions. Models differ more in the hedges than in the prices. Model risk issues have arisen in a number of contexts. The interested reader is invited to consult the literature and the references . . Model Risk and Risk Management Models stand at the cornerstone of risk management. Models characterize the behavior of financial instruments under different possible environments. This information is used to determine the risk of these instruments, and thus of departments, and ultimately of the corporation with respect to the markets. We have exhibited a variety of model calculations. We need to understand the model limitations. These limitations translate into a risk associated with the very models used for assessing risk. Model risk results from model limitations. . Liquidity Model Limitations There is a variety of other problems not included in models. Effects related to supply and demand, the trading volume, and the time needed to sell a security are lumped together into "liquidity", and there are no good way to model these effects. Often they are just left out of the model price. Bid-offer spreads are a related issue. If there is only a one-sided market so that (for example) the selling price is not known, then these spreads must be estimated independent of the model algorithm. . Which Model Should We Use? Because there is no real theory of finance in the sense of physics, financial models are not unique. Different institutions, especially for illiquid financial products, often use different models. If one model is used in place of another, the differences in the values of the securities and the differences in the sensitivities with respect to movements in the underlying variables become an issue in risk management. For example, if one model reports the interest-rate dependence of a partially hedged position is near zero while another model just as sophisticated and defended with at least as much exuberance reports that the interest-rate dependence of the same position is large, which statement do you believe? Sometimes a proprietary desk model is used for trading, and another model with simpler assumptions but widely used on the Street is used for corporate risk management reporting. Which model should be used to measure risk? The real answer is that there is model risk. Different models give different results. Therefore, there is an uncertainty in risk reporting due to the very existence of different models. A corporate goal should be the quantification of this model risk, creating an uncertainty of risk management itself. . Psychological Attitudes towards Models The psychological attitudes toward models are not to be ignored. People who do not understand the limitations of models ask for the "best" model, and some people who should know better may believe they have the "best? model. Some people trust the models to such an extent that if their model disagrees with the market they assume the market is "wrong" and will eventually agree with the model. Sometimes this attitude pays off and sometimes it results in disaster. Sophisticated players understand and even fear the limitations of the models, sometimes using them only as a guide in difficult markets for illiquid products. . Model Risk, Model Reserves, and Bid-Offer Spreads Models used for risk management are themselves risky to some extent. A corporate reserve could be taken to account for this model risk. This is difficult to convey to accountants, who want to know exactly how much the model risk is and exactly when or under which conditions they should apply the reserve. Because model risk will really show up when relatively illiquid positions are sold in difficult market conditions under pressure at someone else's model price, the risk is hard to quantify. Still, model risk is not zero and may be very large. Alternatively, if known, model risk can be used to estimate part of the bid-offer spread for illiquid products. . Model Quality Assurance The best way to quantify model risk is through a model "quality assurance" (QA) program (c.f. Ch. 33). Model QA now exists in most large financial institutions, although model risk is generally only determined in an incomplete fashion. Model assumptions and procedures are documented. Sensitivities to different parametric assumptions can be examined. Models can be assessed and compared. . Models and Parameters Because there is no financial model that proceeds from first principles that are unambiguously correct, models are largely driven by parameters. These parameters are chosen through a combination of somewhat conflicting goals. The parameters are chosen such that the model into which the parameters are placed produces prices that, at least approximately, fit selected market data. The difficult problem is for cases where there is little or no market information. Models differ partially because the market constraints placed on the models can be chosen in different ways. The number of parameters is a compromise between fitting the known market prices and unwieldy complexity. Having chosen the parameters to fit the market approximately, the models can be viewed essentially as providing an extrapolation or interpolation methodology. Thus, if a deal comes up that has parameters not currently quoted in the market, which is often the case for over-the-counter deals, the model is used to derive a price for that deal. The models, through extrapolation or interpolation, price illiquid instruments in a portfolio. It should be emphasized the types and numbers of parameters in reality form an integral part of a model. In a profound sense, the parameters cannot be separated or isolated from the assumption of the underlying dynamics and the implementation of the mathematics through some computer algorithm. For example, if one volatility is used to describe a diffusion process rather than several volatilities, this is a model assumption. In fact, some models are just shells into which complex parametric functions are inserted. The Black-Scholes equity option formula is currently used in practice with a breathtaking richness of the parameterization of the volatility "surfaces" describing different options including ?skew? effects. The volatilities cannot be separated from the assumption of simple diffusion and the algorithms used. . Too Much Mathematical Rigor in Finance? ? following Feynman (ref: Feynman and Hibbs), it is difficult see the utility of a full-court press for rigor when financial models are only approximate, i.e. various assumptions behind the models are manifestly violated in the real world. There is, moreover, a serious case against too much mathematical rigor in finance. Rigor can hide irrelevance. Rigor teaches us nothing new of practical importance. Rigor can be counterproductive because it makes the subject appear harder than it really is. The worst is that rigor gives a false sense of model validity. The use of excessive rigor in finance parallels physics in the 1960?s for the mathematically rigorous axiomatic field theory. One paper (Gell-Mann et. al) put the situation in perspective: ?In particular, the contribution of axiomatic field theory to calculations has been less than any pre-assigned positive number, however small?. ? © 2009 Jan W. Dash. All rights reserved. ---------- Quant Finance Sat, 10 Jan 2009 14:09:00 --0100 http://www.wilmott.com/blogs/jandash/index.cfm/2009/1/10/Models-Phenomenology-and-All-That http://www.wilmott.com/blogs/jandash/index.cfm/2008/11/6/The-opera-Dr-Atomic John Adams? opera Doctor Atomic puts a human dimension on the origins of the atomic bomb, and refocuses attention on nuclear weapons, which still constitute a clear and present danger to humanity. The opera is very powerful. The libretto is largely taken from contemporary historical documents, some recently declassified, along with some poetry. Doctor Atomic is J. Robert Oppenheimer. The music is effective, although the score is difficult; I managed to get a full score on loan to study. The staging is riveting. I saw the original opera in San Francisco and again recently at the Metropolitan Opera in NY. An HD film of the opera has been made for showing at selected theatres. If the opera comes your way, it is an opportunity that should not be missed. There is now an excellent DVD available, pictured at left. A great new PBS ?Independent Lens? documentary on the opera and the history has appeared. See http://www.pbs.org/independentlens/wondersaremany/ -------------- Music Thu, 06 Nov 2008 12:58:00 --0100 http://www.wilmott.com/blogs/jandash/index.cfm/2008/11/6/The-opera-Dr-Atomic http://www.wilmott.com/blogs/jandash/index.cfm/2008/9/21/3rd-printing-of-Quantitative-Finance-and-Risk-Management-A-Physicists-Approach World Scientific is going to reprint my book again, since the earlier two printings are almost sold out. The book title is ?Quantitative Finance and Risk Management, A Physicist?s Approach?. The attached file specifies a few typos that will be corrected in the 3rd printing, the titles of several new brief sections that were added, and page numbers for minor changes/additions. My earlier blog post on June 6, 2006 4:37 PM has the errata page for the 2nd printing, plus some Wilmott URLs for discussions of the book. The IAFE (International Association of Financial Engineers) has the book on its suggested derivatives books resource list: http://iafe.org/html/resources_books.php [edit] The 3rd printing is done. ---------- Book Sun, 21 Sep 2008 14:34:00 --0100 http://www.wilmott.com/blogs/jandash/index.cfm/2008/9/21/3rd-printing-of-Quantitative-Finance-and-Risk-Management-A-Physicists-Approach http://www.wilmott.com/blogs/jandash/index.cfm/2008/9/2/The-Large-Hadron-Rap--watch-me Far Out! Watch the music-rap video ?The Large Hadron Rap? to learn about the big new high-energy particle accelerator at CERN in Switzerland, and the physics behind it. http://www.youtube.com/watch?v=f6aU-wFSqt0 The rap, besides being fun, is scientifically accurate. High-energy particle physics used to be my world. For some background see: http://public.web.cern.ch/Public/Welcome.html http://www.comcast.net/articles/music/20080901/ODD.Particle.Physics.Rap/ ---------- Physics Tue, 02 Sep 2008 13:48:00 --0100 http://www.wilmott.com/blogs/jandash/index.cfm/2008/9/2/The-Large-Hadron-Rap--watch-me http://www.wilmott.com/blogs/jandash/index.cfm/2008/8/15/New-York-Grand-Opera-Update-2-Aida-performance The Aida performance was held on Aug 13th. The picture shows the scene when the messenger delivers news of the invasion of Egypt, led by Aida?s father, setting up the opera plot. I?m behind the messenger (priest furthest stage right), and did the backstage chorus conducting. See you next year in Central Park for more opera by the New York Grand Opera. For more information see: http://newyorkgrandopera.org/ ------------- Music Fri, 15 Aug 2008 14:08:00 --0100 http://www.wilmott.com/blogs/jandash/index.cfm/2008/8/15/New-York-Grand-Opera-Update-2-Aida-performance