Valuation and risk management, two sides of the quant business, must be treated with equal sophistication, with equal respect, and with equal suspicion. And there must be closer interaction between them.

In education, valuation should not be the domain of the most abstract of mathematicians with risk management its more primitive partner. In practice, quants must not produce models that risk managers cannot understand.

At every stage of valuation and model development you must be asking questions about risk and robustness. It is dangerous to come up with some fancy model and only afterwards start asking questions about model error. Anyone who has ever calibrated a model knows that the methods used to mitigate model risk almost come as an afterthought, and are totally inconsistent with the original model. This need not be the case.

In the CQF we treat valuation and risk management as equals. The structure of the CQF is unashamedly mathematical. Module by module we add mathematical flexibility, and in each lecture you will see model risk and model robustness discussed alongside the theory of valuation. This is how quantitative finance ought to be taught. This is the mature approach to the subject, and it will help to resolve many of the discrepancies between finance theory and finance practice.

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I was at the G20 protests in London on 1st April. I took this photograph of the 'charming gentlemen' who were supposed to be keeping the peace. As we know they were instead beating people up, and slapping women around, hence their disguises. I mention this now because I've just seen a BBC story in which an MP is reported as saying that "police must modify their behaviour in an age where their actions were easily filmed by the public." Translated this means that if they are not being photographed then they can do what they like. A bit like MPs and their expenses, if no one can see what they are up to then they should be expected to get away with what they can.

It seems to old-fashioned me that police, MPs, anyone with a position of responsibility in public life, should have the personality and self control to stay within the letter and spirit of the law and be role models for everyone else. This is Britain, not Italy!

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Remember my blog about Magicians and Mathematicians in which I complained about the lack of imagination in risk management? If you don't, then please take a look otherwise the rest of this blog won't make any sense to you at all!

Well, I just had a very frightening experience at a conference. I used the magician example to get the audience to open up to the idea of thinking beyond the simple mathematics. I started with "What is the probability of...," and received the usual "One in 52" reply. Then the location (the magic show) was pointed out, and people changed their answer to 100%. Except that some people didn't. There were three people in the audience of maybe 100 who stuck to their original 1/52 answer and refused to budge.

So far so typical.

Now the frightening bit. The audience consisted almost entirely of actuaries. (That's not the frightening bit!) Except for three people from the FSA. And two of those were ones who insisted on the 'math' answer 1/52. (That's the bit that scared me!)

One of them explained his reasoning. I cannot remember the details, it was quite lengthy, but the essence was that "The answer should have been one in 52 except that the magician was tricking us and so really we should ignore this factor..." (I apologise if I have got this wrong, but from the reaction of the audience I don't think I have!)

Now forgive me but isn't the FSA supposed to be operating in the real world in which things are just not about pure mathematics? A world in which risk managers hide risk, moral hazard is rife and magicians do, er, magic. Isn't that sort of the entire point? If it was all about the maths then we wouldn't have the FSA, we'd use someone like the EdExcel examiners to give banks marks out of a hundred at the end of term.

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Denial, anger, bargaining, depression, acceptance, according to Elizabeth Kübler-Ross the five stages of dealing with personal tragedy. I wonder if there's something similar we are going through with financial derivatives? If so, I think Warren Buffett is at the anger stage. "If you need to use a computer or a calculator to make the calculation, you shouldn't buy it," is his view on investing, famously calling derivatives "Weapons of mass destruction" a few years ago. I sympathize, and I speak as one of the mathematicians who works with derivatives for a living.

In my experience there are just four stages of dealing with derivatives, and they are: naive enthusiasm, as one experiences the glorious possibilities of derivatives in one's portfolio, then righteous anger as one suffers horrendous losses, followed by confused disbelief, as one realises that no one fully understood the risk in these dastardly creations, least of all the bankers, and finally a reluctant acceptance as one admits that these things are here to stay. Let's go through these stages one by one, while I explain what each means in terms of risk.

Naive enthusiasm: Derivatives are wonderful financial contracts, they allow you to finely tune your investment portfolio to benefit from your market views, assuming they turn out to be correct. My bank manager has recently been trying to sell me a contract that will give me over 5% return in one year if gold stays within a certain trading range. In market parlance this is called a double knockout quanto option. Or derivatives can be used to hedge risk from other business activities. If you regularly sell widgets to Japan you are exposed to dollar/yen exchange-rate risk. A derivative can be designed to reduce that risk for you. So far so good.

Righteous anger: Who wouldn't be angry after the trillions of dollars that have been lost thanks to CDOs, MBSs, and all the other acronyms? The problem though is not the derivatives themselves, rather the way that the derivatives have swamped the market for simple stocks and shares. The notional outstanding of all derivatives globally is over a quadrillion dollars. What, you thought trillions was bad enough? You, ain't seen nothing yet!

So rather than derivatives existing to help you manage risk, or profit from precise market views, the market has grown so much that derivatives seem to be there just to allow crazy leverage, risk taking on levels never seen before. And at this point the risk-management quants step in to say, don't worry we've got our fancy mathematical models that show there is actually no risk.

Buffett's right-hand man, Charlie Munger, has said about higher mathematics in finance "They teach that in business schools because, well, they've got to do something." Now that really hits the nail on the head. When your competitor university across the river is charging 50, 60, 70 thousand dollars for a one-year Masters course in Financial Engineering, what are you going to do? Are you going to say you don't have any faculty that understand derivatives? Hell, no. You are going to get your smartest mathematicians together and make up a syllabus. Are your 23-year old victims, sorry I mean students, going to know any better? In 2000 I warned about the dangers of a "mathematician-led market meltdown" after seeing what had happened at LTCM and how identikit risk managers were being churned out from Masters programs, and how Groupthink was beginning to dominate risk research and derivatives valuation. I sympathize totally with Warren Buffett and Charlie Munger.

Confused disbelief: I'm a great believer in education playing a bigger role in derivatives in future. But not the sort of education that we've got at the moment. I understand Warren Buffett when he says "The more symbols they could work into their writing the more they were revered." Universities are churning out many thousands of 'experts' in the analysis of derivatives but sadly they know more about the math and the symbols than they do about the markets. But again it's not the symbols themselves that are to blame, for we happily fly on airplanes designed using similar symbols, rather it's the lack of financial empathy exhibited by the multiple-PhD'd analysts, the quants, that worries me. Remember this is a mathematician writing this, but one who has been saying less is more for over a decade now.

Reluctant acceptance: I've blogged in the past about the "mathematics sweet spot" for finance, where the models are not dumbed down, but equally they are not fantastically over complicated (to impress, as I expect Buffett would say). I don't think we can go back to a dark ages before derivatives and quantitative finance, but I do believe that we desperately need to rethink the type of education that those 23-year olds, soon to be in charge of your pension, are getting. Less math, fewer symbols, more commonsense, and more market know-how.

And in this respect I think I'm a few stages ahead of Mr Buffett.

No, nothing to do with swine flu this time, I'm talking about those other greedy pigs, UK politicians, and their obscene behaviour over expenses.

My view is the opposite of everyone else's. You'd expect nothing less from me!

Let them keep their expenses as they are.

The rules concerning what they can and cannot claim for are nicely vague. And as with most things legal there is the letter of the law and the spirit of the law. The decent politician will abide by both, he is there to serve the people not to make a profit every which way. Their salaries are more than adequate for what they do. So the decent politician will claim for little, if there is any question about a claim then he will err on the side of caution. The greedy politician will do the opposite, and claim whatever he or she thinks he or she can get away with. Many such politicians seem to have legal training so they are well practiced in lying and prevaricating, justifying their greed. But no one's fooled. (Of course, this may all be 'theoretical' as the 'decent' politician became virtually extinct in the UK just over a decade ago.)

So the current system is a great way of 'signalling,' as economists say, something about the character of individual politicians. Change the system by taking away expenses and it becomes harder to tell which politicians to trust and which to distrust. Right now we all now who not to trust, we have a very long list. Come election time I hope UK voters will use that information.

Or maybe I'm being idealistic, it wouldn't be the first time. Because the system also gives information, signals, about the voters. If politicians can get away with what they are doing then it tells me that the British people are really no better than the politicians.

Plan B is to get rid of expenses, and insist that MPs stay in a cramped dormitory when in London and travel on public transport, bring them back down to earth. Either way it would be nice to know that politicians had the common person's interests in mind, rather than their own wealth and pension.

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A couple of years ago I damaged my right hand trying to hold open the door of a London Underground train. For about 18 months I was unable to shake hands, especially with Americans. I just happened to be reading the autobiography of Ron Jeremy, legenday porn star, at the time, a book I would very highly recommend, in which he mentioned the "porn handshake." Apparently, and I emphasise that I only have his word for this, that when two porn stars meet on set instead of shaking hands, for who knows where those hands have been, they touch right elbow to right elbow. So I started doing this, because of my damaged hand, and for a while this became known as the "quant handshake." It only really caught on within a very small circle and then died out.

Time to bring it back for the general population...

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It is almost impossible for the layperson to rationally determine the seriousness of any new disease and whether it has the potential to be the next Black Death. I'm thinking of the new Swine 'Flu, which has replaced the old Bird 'Flu as the latest Terror. It's impossible to judge because of the modern tendency to dismiss science in favour of tree hugging, hippy, holistic nonsense. And the commercial needs of newspapers who have to make mountains out of molehills to sell in this internet age. Not to mention the internet itself which encourages fear and belief in conspiracy theories. And ambulance-chasing lawyers causing us to overreact to everything to avoid lawsuits.

I have no doubt that a new human virus is of more danger than global warming, and for the record I'd like to add other things that are of more pressing concern than global warming: terrorism; cyber attacks; computer viruses; (even worse) global financial meltdown; everything really thanks to the 'global village' problem.

So I have my own way of determining the seriousness of any new threat to human life, it's called the Celebrity Death Test, and I hope you find it useful. The way it works is simple, if a Celebrity dies from the Threat then it is to be taken Seriously, if they don't then it's probably nothing to worry about. Bird 'Flu, fine. AIDS, not fine. I can remember when Rock Hudson died, that was the moment when AIDS became real for me. (I'm also a fan of Doris Day, read into that what you will!) You see how it works? It's just a statistics thing. If a Celeb suffers from it (and assuming it's not something that has a natural correlation with Celebrity or is self inflicted) then it is statistically significant for the rest of us.

BTW your intrepid reporter is due to lecture in Mexico City in a few weeks. All being well I shall give you news from the frontline, possibly from behind a face mask.

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First my standard disclaimer, Economics Makes My Brain Hurt. I am but a mathematician, and businessman, I suppose. And although I cannot and do not claim to know anything about running a country (which is at least an honest position, one I wish were shared by those temporarily in power), I can draw on my own experiences and on simple logic.

It seems to me that the choices facing the UK government now are not dissimilar to those that might be faced by anyone running a household or a business, e.g. me.

When in debt you have limited choices:

a) Make more money. For the individual this means getting another job. For the government it means increasing tax revenues, which may be the same as increasing taxes (or it may not, depending on disincentives so introduced). Keeping the numbers simple, the goverment/IMF is talking about £200billion debt. Divided across the UK population not such a big number, but still enormous for the man in the street, divided across the rather smaller 200,000 high earners that the government has in its sights, hmmm, not such a small number. However you divide it up though it's all quite frankly impossible (unless you believe Darling's forecasts for growth in 2010, which I don't think even he can believe).

b) Cut spending. Painful for a Labour government (or New Nasty, as I now call them after the scandal of the attempted email slurs), but at least there is lots of waste they've introduced and which they could cut out. But no, cutting waste and public spending is not what Labour do, it's a vote loser.

c) Sell off the silver. Any foreigners want to buy a piece of the UK right now? Going cheap. But wait a while, the country will be even cheaper.

But there's one thing that the public cannot do, and which only governments can, and that is make the debt disappear like a David Copperfield trick. No mirrors, no distracting bright lights, no body doubles or revolving stages (sorry if I'm giving away his secrets!), just simple inflation.

d) Inflate, reduce the value of the pound. Debt disappears (compound interest acts remarkably quickly). And a vote winner among all the borrowers who started this mess. Of course there is the slight problem that the 'independent' Bank of England (made so by Gordon Brown in 1997 remember) has a specific remit to control inflation. So watch out for subtle changes in the BoE rules.

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Are you a numbers person or a symbols person? You should instinctively know the answer. Let’s step back a bit, are you a cat person or a dog person? A cat person? Like me then. You can’t be both. Again, numbers or symbols? Do you like your mathematics done with examples involving numbers or more abstractly with symbols? If you have a maths degree then you are definitely a symbols person, also probably if you have a hard-science background. But accountants prefer numbers.

Numbers are great for illustrating how things work. Add, subtract, multiply, divide, raise to a power, etc., you can’t fool anyone with numbers. If it can be done with numbers then it must be easy. On the other hand with numbers you can’t see structure. If the number 7 appears in some calculation you won’t necessarily know what it means. And is it the same “7” each time it appears? Maybe one is an interest rate and another is a maturity. To get to a deeper level of understanding you need symbols.

Symbols are great for showing structure, abstraction is always necessary if you are to go beyond mere arithmetic. The problem with symbols is that some people are frightened by them. And if you and I are used to using different types of symbols it may take some time before we fully understand each other. One could even be accidentally or deliberately confusing, throw in a symbol without a proper explanation and before you know it everyone is lost.

This is relevant to the teaching of mathematics in schools. People can become terrified of the subject at an early age if taught badly, with the result that they are probably forever lost. (Unless it’s possible to get therapy?) How often at dinner parties have we mathematicians heard the ever-so-original response to what we do for a living “I was terrible at maths at school, me!”? I read recently that the part of the brain that does maths is right next to the part that registers fear. I don’t know whether it’s true but it certainly makes sense.

I am forever hearing politicians wittering on about how maths education in schools needs to be made more fun, and more, what’s the word? Practical! Misguided fools! Not a single GCSE maths above grade D among them. The point of mathematics is that it is supposed to be abstract. If all your maths comes from counting apples then you are going to be stymied by the real thing. Mathematics is abstract, that is the beauty of it. And that’s what actually makes it fun. Teach mathematics properly, don’t terrify children by asking them how long it takes ten politicians to dig themselves into ten holes, explain to the young the beauty of the abstract.

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The Peter Principle (named after Dr Lawrence Peter) is the idea that people “rise to the level of their own incompetence.” Originally it was proposed in a humorous book published in 1968 but has since become accepted as giving genuine insight into how humans interact. According to Wikipedia “It holds that in a hierarchy, members are promoted so long as they work competently. Sooner or later they are promoted to a position at which they are no longer competent (their ‘level of incompetence’), and there they remain. Peter’s Corollary states that ‘in time, every post tends to be occupied by an employee who is incompetent to carry out his duties’ and adds that ‘work is accomplished by those employees who have not yet reached their level of incompetence.’” This is related to the concept that everything interesting happens at the margins.

The same is now clearly true of larger organisms, and I am obviously thinking of western society as a whole. The evidence is unambiguous: Bonus-bewitched bankers destroy institutions that had been around for centuries, politicians rescue their rich friends and ensure they get handsomely rewarded for their catastrophic failures, then people protest peacefully at the G20 summit where the police are the aggressors.

This has been made possible by ‘progress’ thanks to technology, the Ponzi scheme that is the world economy, the lawyer-led victim culture, the abandonment of common sense because of political correctness, the advance of globalization so that we are all tied together in one giant global-village/shopping-mall and the ubiquitous career politicians having no productive real-world experience but who know how to crawl their way to the top, lining their pockets all the way, over the bodies of the hard working and what are now called the ‘coping class.’

Senior management being paid in inverse proportion to their achievements; Personal Identification Numbers everywhere so that we are forced to use the same one every time therefore increasing the security risks they were meant to reduce; Health and safety rules that mean we are not permitted to experience the small pains that stop us from suffering from the deadly; There being so much new legislation that most people commit a petty, trivial crime each day, while real criminals go unpunished; No one being allowed to fail, all students must be given an A grade so it is impossible to tell who is fit for a job, while simultaneously lying on CVs is encouraged; The BBC being unable to spell its news announcements correctly, they happen so quickly; Over-paid professors proposing that spelling be relaxed because children find it too hard; Children unable to play in the streets because of hysteria over paedophilia; Children unable to learn contact sports properly because teachers are not allowed to touch them; People allowed to drown because ‘rescuers’ didn’t have the right ‘certificates’; People vying to be in minorities so as to get special treatment; Bins too heavy for binmen; Fines for not sorting rubbish; Homeopathy; Creationism;…

On my street recently a man was deliberately run into by a car and carried around the neighbourhood on the bonnet. The man suffers from MS. The police did nothing, even though they have a CCTV camera in the spot and it recorded the whole incident including the car’s number plate. But they manage to use the same CCTV on the same road to record parking violations and issue tickets without any problem. The reason is obvious, fining people for parking is profitable, solving crimes is not. And according to en vogue theories every part of society must be a self-sufficient, profit center, mustn’t it? Utter madness.

Society has risen to the level of its own incompetence and at the same time the means to return to a more sensible world has been legislated out of existence. The above we all know. But only some of us really care. If you are one of us, you will already know the solution, but you are perhaps understandably afraid to carry it out. The solution is this…I ask please do your best to bring back freedom of speech and expression; Please be politically incorrect at every opportunity; Tell jokes that are in bad taste; Travel on trains without a ticket, and then for your court appearance hire Cherie Blair as your barrister. Laugh in the faces of health and safety personnel! Edmund Burke, the political philosopher, is attributed with the saying “All it takes for evil to triumph is for good men to do nothing.” I’m not worried about evil, it’s stupidity that is soon going to be victorious. But the world can only continue its descent into madness if you let it.

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I apologize in advance for this mini blog. But you all now expect me to get things off my chest, and I do like to tell it how I see it. Nevertheless this still pains me. (And I think I may have resisted temptation, but the title of this blog was just too good an opportunity to pass up.) So here goes...sequins, Argyle check and a pearl necklace...Michelle Obama, what were you thinking? There, said it. Let's move on.

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As I write this I have not seen details of the G20's agreement and related events. So I'm going by soundbites and rumours that I've heard in the last few hours. Nevertheless, I can't resist a few quick comments.

First, Gordon Brown has talked vaguely about only rewarding bankers for positive performance. Well, believe it or not, apart from packages paid to the likes of Fred Goodwin, that is exactly the current situation! And it is this that encourages risk. Compensation needs to be tied to maturity of contracts. And diversification within institutions needs to be encouraged. We have to align the interests of bank employees with the interests of depositors. I'm still not convinced that those in power get this yet.

I understand that mark-to-market is being relaxed in parts. I approve. I just wish that banks had been nationalized first so that the taxpayer would have benefitted from this. Again banks have "upside exposure with no downside risk" as they say in the prospectuses. For the taxpayer it is the opposite, so no change there.

And finally, they are going to be publishing a list of bad tax havens in order to shame them. Isn't that rather like telling teenagers where to buy the cheap alcohol? At the moment we have no idea where to put our money, since once-respectable banks are no longer safe. But this time tomorrow we'll all know exactly where to go!

I'm being harsh, you say. They mean well. Oh, yes, I'm sure they do!

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In the popular press I keep reading about how quant models need to be improved. It's not as simple as that, but nor is it so subtle for the journalists to have to dumb down.

There was an article in the Financial Times last week that said we need more maths, yes, more, lots of it, until we are stuffed to the very brim. No mention of what sort of maths, no mention of the relevance of the maths or the robustness of the resulting models. Just "we need more maths." I have to disagree that it is just a case of more is better. The wrong models are partly responsible for the current mess, and many of them are too mathematical. Well, I've said that many times over the years.

There's also the perception that there are no good models out there. Again, I have to disagree strongly. There are plenty of models that are better than the established models. Some of them are better by virtue of being more accurate in a scientific sense, some are better by virtue of their simplicity. Given that financial models are never going to be perfect it surely makes sense to have models that are transparent and easy to understand (and mend when they go wrong) rather than complex and impenetrable.

One error that keeps being repeated is that there are no models for crashes, when all instruments move together in sync. Well, the much-maligned-and-rightly-so copulas are meant to do that. Clearly they didn't do a great job. There is also the model that Philip Hua and I designed in the mid to late '90s, CrashMetrics.

CrashMetrics ticks all the important boxes: a) accuracy, b) correct level of mathematics, c) understandability, d) robustness, e) flexibility, f) ease of use. We came up with the idea because it was clear that Value at Risk would only work during rather dull markets, that is, perversely at times when it almost wasn't important to measure risk! So something had to be done about the bank-destroying events, the crashes for example. Extreme Value Theory was supposed to do that, but that's just "rearranging the deck chairs on the Titanic." CrashMetrics is a worst-case scenario model, designed to tell you how bad the crash would be for your portfolio, with no reliance on probabilities. Once you know what the worst could be you then decide whether you want to protect yourself against it, and then, thanks to "Platinum Hedging," the methodology also tells you how to do this in the optimal, most cost-effective manner.

Sadly CrashMetrics fails to tick the most important box of all, the so-complicated-that-only-a-handful-of-people-with-17-PhDs-each-can-understand-it box. Silly us!

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Governments around the world are fumbling their way through the darkness trying to get out of the current mess that their banking friends got us into. As far as I can make out the politicians are not asking the advice of independent experts in this matter. None of the people I consider to be truly excellent in this field have been asked for their advice. Mind you, the number of people I think are truly good is pretty small! No, governments are still talking to their banking pals. In a sense that would be fine, speak to the burglars about how to protect your valuables, but only if those burglars have turned over a new leaf. Sadly there is every indication that the current bunch of criminals is still as hell bent on stealing our money as they ever were. Look at the RBS and AIG bonuses. (Aside: Whatever happened to lawsuits for Director negligence? It’s taken two council pension funds to start one against RBS, why is this not a government-backed initiative? Could I, a couple of years ago, have gone into my local bank, asked to borrow £20million in the name of one of my companies, taken it to my local casino – conveniently, and rather fittingly, actually next door to my bank where I live! – bet it all on red, kept any profit, paying off the loan, or walked away from any loss citing ‘limited liability’? Damn, I wish I’d known this before! Second aside: Lord Myners and the rest of the UK government have long outstayed their welcome, it’s time for them to bow out disgracefully.)

I am reminded of a conference on earthquake and other catastrophe insurance that I attended in Zurich several years ago. One lecture, given by a financial consultant, concerned modeling the losses caused by hurricanes. He showed a plot of how wind speed varied with distance from the centre of the hurricane. It was a plot that looked something like shown here. And the thrust of the lecture was how to model this mathematically.

Now, before I say anything else, if there are any fluid mechanics reading this, be warned, what follows is shocking, hilarious, and also insulting.

Ok, so how do you model the wind speed as a function of distance from the centre?

There are different types of fluid flow: viscous, invsicid, compressible, incompressible, turbulent, rotational, irrotational, etc. Which one you’ve got depends on speed, various parameters, geometry. A simplifying assumption for a hurricane is that of symmetry, that the air rotates about the centre. In the middle the speed will be zero. There are two simple symmetrical flows for large speeds, one is irrotational and the other rotational with constant vorticity. As functions of distance from the centre the former is inversely proportional to distance and the other is proportional to distance. So if you have a central core that is rotational and join that up to an irrotational region outside you pretty much get what is shown in that link above. It can be refined to allow for rotation of the earth and other important effects. But this first stab at the problem is basic, second-year undergraduate hydrodynamics.

So what did the financial consultant do? Working in finance, all he knew about was probability theory. And so he looked through his big book of probability distributions and picked out one that had the closest fit to the empirical shape. What?!?! Airspeed has little to do with probabilities! He may just as well asked which constellation of stars gave the best fit! I was so shocked by this and embarrassed for the man that I stupidly did not ask him whether he had the slightest inkling of what he was doing. He clearly didn’t, but then his audience equally did not have a clue. (Third aside: More often that not I find myself in the position of watching the blind leading the blind. I’ve blogged on this before here. Quant conferences can be highly amusing, until you realize that people take their models seriously and so do others and, most importantly, they have an enormous impact on the rest of us.)

And that’s where we are now, as governments try to solve the current crisis…so that they will be re-elected.

Unfortunately they are somewhat constrained by also having to keep their chums happy, by making sure they get their big bonuses, while also maintaining the banks as private sector so that when they fail to get re-elected they will have well-paid City Directorships to step into.

P

Final aside: The wife of professional liar and ex-PM Tony Blair, Cherie Booth, is involved in the lawsuit against RBS. Is she acting pro bono? If not then you have got to admire the cheek of these people: Blair and Brown encourage the bankers to act irresponsibly causing untold harm to the taxpayer, the taxpayer then pays off these banking bosses with enormous bonuses and pensions as a reward for destroying the banks which the taxpayer then has to rescue, public outrage follows, so wife of ex-PM steps in and gets paid to sue one of the aforementioned bosses. Who wrote this script? It’s an Orwell-Adams production of a Lewis Carroll screenplay directed by Terry Gilliam. Pinch me!

There's a well known phenomenon in aerodynamics in which a plane's flight controls appear to do the opposite of what is intended. This can happen at high speed, for example. (I have a vague memory of a movie supposedly about Chuck Yeager breaking the sound barrier, and there being a tense moment in which our hero had to decide which way to move the controls. Should he pull them the traditional way as advised by all his colleagues? Or do the opposite as his instinct said? Obviously he followed his instincts! I don't know how true any of that is!) This inspires the obvious thought...

Raise interest rates.

I'm not suggesting that there is any link between economics and aerodynamics. And my position on economics has been documented. So don't necessarily believe anything I say on the subject. However, there can be no doubt about the pointlessness of continuing to decrease interest rates. It has become a joke; 1%, 0.5%,... This strategy is about as effective as a visit to a witchdoctor.

If governments are in the business of bailing out more and more banks, and if they are about to start printing money/quantitative easing then raise interest rates at the same time. Bring back some semblance of normality for the man in the street.

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Remember CDOs? Of course, you do...although no one is trading these monsters anymore they continue to wreak havoc to the global economy.

We still teach about them on the CQF. Why? Maybe they'll come back one day, maybe with a different acronym, or if they don't then they are at least a fantastic teaching aid for showing how not to model and how not to risk manage.

Hang on a second. Have they really disappeared? I'm not so sure they have. What's that recent deal that the UK Treasury has just done with RBS? It looks scarily familiar...something to do with $325 billion of toxic assets (no doubt including a few CDOs and CDO^2s) and divvying up different levels of risk?

The balance sheet of RBS is £2.3 trillion. In return for £6.5 billion in some dodgy non-voting shares the UK Treasury is going to be insuring some of that £2.3 trillion. The first £19.5 billion is RBS's responsibility, after that the taxpayer takes care of 90% of the rest of the $325 billion.

Sound familiar? Yes, the UK Treasury has just got itself the mezzanine tranche of a CDO!

Observations:

1. This "Mother Of All CDOs" that the Treasury owns is mezzanine tranche, the hardest tranche to value and risk manage.

2. Assuming there are CDO^2s in the portfolio this is now officially a CDO^3.

3. Worst of all, the premium paid to the UK Taxpayer is £6.5 billion in RBS shares. Of course, if things go wrong, as they probably will, then that premium will plummet as the RBS share price plummets. Note to Lord Myners, Alistair Darling and Gordon Brown: When you buy insurance on company X, buy it from company Y, not company X itself.

4. A fall of a mere 8.2% in the value of the toxic assets will wipe out the £6.5 billion. And that's best-case scenario in which the RBS share price doesn't fall!

5. Finally, the shares are non voting so as to give the impression, albeit rather feebly, that RBS has not been nationalized. Look, the Taxpayer owns 90% of RBS, and can vote on 75% of the shares. Why keep up the charade? Nationalize all dangerous banks, across the globe, immediately. Guarantee the deposits of the man in the street. And clean up the mess in an atmosphere of relative stability.

The UK Treasury is being advised by a bunch of dodgy Sirs and Lords, none of whom have a clue about what is going on or what to do, none of whom have any qualifications in risk control. But I'm sure all of them are jolly good chaps to have a glass of port with in the clubs of St James's.

P

Felix Salmon has written an interesting piece on the copula model. Naturally the model does not come out well. He quotes me, accurately, as disapproving, to put it mildly, of models that depend on correlations between companies.

But that's only part of the problem. Far more serious, because it extends to all of finance not just to a single model, is the poor education that people get in university financial engineering programs and also the blind-following-the-blind behaviour that is so common throughout the industry.

The copula model is not robust to changes in model assumptions. Black-Scholes is. Did you know that? Or maybe I'm wrong. Would you like to know the truth?

Yes, I could tell you. I could spoonfeed you. You've got used to being spoonfed, haven't you? But you're passing the buck there, putting an awful lot of responsibility on my shoulders. I can cope, as I'm sure David Li can cope. But you're a big boy/girl now, you should be able to think for yourself. Isn't that part of your job description?

It's getting quite tedious me telling people to get off their backsides and test the models for themselves. Don't believe anything I say, don't believe anything Nassim, also quoted in the Salmon article, says. Question everything. Switch your brains back on.

In the late 1970s I had the dubious pleasure of attending a Billy Graham evangelical event for the followers of the christian cult, as a guest of some born-again nutters. Over the last decade I have had the equally dubious pleasure of attending many conferences on credit, listening to various academics, let's say "Professor X," for example, preaching about the copula cult. I use the word 'cult' in this context because of the similarities between the unthinking adoration I witnessed at both types of event. I found the Billy Graham event hilarious, I found the credit events disturbing. In both cases the audiences were intelligent people, in both cases there was only one non-sheep among them: me.

Paul Volcker recently spoke about financial engineering and it being, er, not quite what it's made out to be. Setting aside the obvious discussion of what took him, and so many others, so long to realise this, he did make one point that matches my experience. And that is the use of the "Nuremberg Defence" by financial engineers, "Don't blame me, I was only following orders." I agree with Volcker that this is pathetic. And I've heard the same excuse from hundreds of people over the years, well before the recent crisis. I will be teaching people about the boundless possibilities of mathematical modelling, far beyond anything in most textbooks and certainly beyond anything in university programs, or I'll be explaining the dangers of Value at Risk, etc. and the audience will almost invariably say that they'd like to try out the new ideas when they get back to their office...but...but...but they won't be allowed to because the bank's policy is to use 'here insert name of stupid model that they've never properly tested.'

Gentlemen, and ladies, look in the bottom drawer, or wherever it is that you put them, and get out and dust off your cojones. Stand up, be counted, and stop bleating.

P

When it was first proposed that banks should put all their troubled or toxic assets into separate banks or vehicles I bet some of you smarter quants were jumping for joy. Up until then you’d been playing that harmless game of “Invent a toxic contract that gives you a big bonus after one year but which blows up as soon as you have moved to another bank.” A pleasant enough game, but one that, it could be argued, had become just a little too easy, perhaps not as challenging as it had once been.

Anyway, along come the politicians who quite frankly know nothing about derivatives and risk management and they propose this plan that on the face of it looks reasonable. But to the quant it’s a very similar game to the one that they’d played before. All you have to do is invent new contracts that are sufficiently complicated that they might pose a danger, they don’t even have to be contracts with any meaningful economic justification anymore. The contract has to be ‘difficult to value.’ But what’s difficult to a government accountant is going to be easy for you guys! Once you’ve come up with a suitable contract, just sell it to a friend at another bank. Pocket the money. And then your friends says “Ohmigod, what have I bought?” And he puts it into the troubled-asset depository. Then you swap roles so he gets to trouser the cash. Result…everyone’s a winner. I leave you to work out the details. You may want to speak to a lawyer first.

There are a couple of plans on the table. Which do you think is better?

Plan A: Put all toxic contracts into separate banks/vehicles. Winners: Bankers. Losers: Taxpayer.

Plan B: Nationalize banks and change accountancy rules. Winners: Taxpayer. Losers: Bankers. (See Moral Hazard for the Masses.)

I think I can guess which one the UK government will go for, judging by their past record!

P

Well not really, of course. But there are some people quietly sitting pretty...

As it becomes generally accepted that the economy of the west is a giant Ponzi scheme, one should reflect on its positive aspects. The last fifty years, from "We have never had it so good" to the calm-before-the-storm's "No more boom and bust," have been considered by many to be golden years compared with the world war-torn decades before, and the iniquities of times before that.

We know all about those who suffered at the hands of Bernie Madoff's Ponzi scheme, those such as Steven Spielberg, Kevin Bacon, and Zsa Zsa Gabor. But where are all those who made money? It wouldn't be a Ponzi scheme if some people didn't profit.

There must be a few celebs who are feeling uncomfortable right now. They are keeping very quiet. But why? They are the lucky ones who are simply benefitting from the Modern Economics, as espoused by many Modern Politicians and Modern Economists.

The secret to benefitting from a Ponzi scheme is knowing when to get out, and who to leave behind to pick up the mess. Just ask multi-millionaire, style without substance, form without function, Tony Blair. I hear that he's looking very cheerful these days.

P

P.S. It wouldn't surprise me in the run-up to the Oscars if a few rumours started appearing about some nominees being winners in the Madoff affair, such is the dirty-trickery that now accompanies this event!

The Lord of Darkness, Peter Mandelson, and I went to the same college, I am embarrassed to admit. (No, I could not have taken the opportunity to push a stake through his heart because he was there a few years before me and our paths did not cross. A pity.) He is now keen to spend billions bailing out our mainly foreign-owned car industry. Seems like yet another waste of money. Funny how you get used to them. “Bailout fatigue”? Looking along the streets it seems that we have more than enough cars already. I know I do, having three myself. Never mind when they are being driven around, you can hardly move for all the space they take up when parked. At least my cars are gorgeous to look at! I can’t help thinking that the car industry, like so much of the economy of the first world, is another Ponzi scheme. We have to keep buying and buying in order to maintain a status quo. We stop buying and everything collapses. There’s an argument here for spending less on ‘stuff’ and more on services, especially those services which are not harmful to the environment as opposed to the manufacture of the stuff that is. I pretty much already have all the possessions I will ever need.

Stop all manufacturing of cars now, unless they meet serious green criteria. And I don’t mean the tiny increases in miles per gallon that you might get from some hybrid over a petrol engine, I mean order of magnitude decreases in pollutants. Not that I particularly care about global warming, I think there are far worse things going to happen in the next decade that will make the global-warming fuss look a bit silly. But I do object to the use of global warming as justification for producing more cars. Stop making new cars until they are truly green, and just mend the old ones if they break down. Until you’ve owned a classic car you can’t fully appreciate the joys of driving for just 15 minutes before having to call out a mechanic!

This reminds me of the Scottish author Iain Banks, a famous petrolhead, who recently sold his collection of classic cars and replaced them with a single hybrid. He used to have a Porsche 911 Turbo, a Porsche Boxster S, a BMW M5 and a Land Rover Discovery. And he bought a Lexus SUV hybrid instead.

Am I alone in thinking this counterproductive?

First he says that he’s getting about 28.5mpg out of the Lexus as opposed to the “low 20s” he got from Porsches and the BMW. See what I mean? The marginal improvement probably did not outweigh the damage caused by the manufacture of the Lexus in the first place.

And, second, it is not humanly possible for Iain Banks, brilliant author though he may be, to drive more than one car at a time. So now there are five gas-guzzling cars on the roads, possibly all at the same time, when before there was just one.

P

The Financial Modelers' Manifesto

Preface

A spectre is haunting Markets – the spectre of illiquidity, frozen credit, and the failure of financial models.

Beginning with the 2007 collapse in subprime mortgages, financial markets have shifted to new regimes characterized by violent movements, epidemics of contagion from market to market, and almost unimaginable anomalies (who would have ever thought that swap spreads to Treasuries could go negative?). Familiar valuation models have become increasingly unreliable. Where is the risk manager that has not ascribed his losses to a once-in-a-century tsunami?

To this end, we have assembled in New York City and written the following manifesto.

Manifesto

In finance we study how to manage funds – from simple securities like dollars and yen, stocks and bonds to complex ones like futures and options, subprime CDOs and credit default swaps. We build financial models to estimate the fair value of securities, to estimate their risks and to show how those risks can be controlled. How can a model tell you the value of a security? And how did these models fail so badly in the case of the subprime CDO market?

Physics, because of its astonishing success at predicting the future behavior of material objects from their present state, has inspired most financial modeling. Physicists study the world by repeating the same experiments over and over again to discover forces and their almost magical mathematical laws. Galileo dropped balls off the leaning tower, giant teams in Geneva collide protons on protons, over and over again. If a law is proposed and its predictions contradict experiments, it's back to the drawing board. The method works. The laws of atomic physics are accurate to more than ten decimal places.

It's a different story with finance and economics, which are concerned with the mental world of monetary value. Financial theory has tried hard to emulate the style and elegance of physics in order to discover its own laws. But markets are made of people, who are influenced by events, by their ephemeral feelings about events and by their expectations of other people's feelings. The truth is that there are no fundamental laws in finance. And even if there were, there is no way to run repeatable experiments to verify them.

You can hardly find a better example of confusedly elegant modeling than models of CDOs. The CDO research papers apply abstract probability theory to the price co-movements of thousands of mortgages. The relationships between so many mortgages can be vastly complex. The modelers, having built up their fantastical theory, need to make it useable; they resort to sweeping under the model's rug all unknown dynamics; with the dirt ignored, all that's left is a single number, called the default correlation. From the sublime to the elegantly ridiculous: all uncertainty is reduced to a single parameter that, when entered into the model by a trader, produces a CDO value. This over-reliance on probability and statistics is a severe limitation. Statistics is shallow description, quite unlike the deeper cause and effect of physics, and can’t easily capture the complex dynamics of default.

Models are at bottom tools for approximate thinking; they serve to transform your intuition about the future into a price for a security today. It’s easier to think intuitively about future housing prices, default rates and default correlations than it is about CDO prices. CDO models turn your guess about future housing prices, mortgage default rates and a simplistic default correlation into the model’s output: a current CDO price.

Our experience in the financial arena has taught us to be very humble in applying mathematics to markets, and to be extremely wary of ambitious theories, which are in the end trying to model human behavior. We like simplicity, but we like to remember that it is our models that are simple, not the world.

Unfortunately, the teachers of finance haven’t learned these lessons. You have only to glance at business school textbooks on finance to discover stilts of mathematical axioms supporting a house of numbered theorems, lemmas and results. Who would think that the textbook is at bottom dealing with people and money? It should be obvious to anyone with common sense that every financial axiom is wrong, and that finance can never in its wildest dreams be Euclid. Different endeavors, as Aristotle wrote, require different degrees of precision. Finance is not one of the natural sciences, and its invisible worm is its dark secret love of mathematical elegance and too much exactitude.

We do need models and mathematics – you cannot think about finance and economics without them – but one must never forget that models are not the world. Whenever we make a model of something involving human beings, we are trying to force the ugly stepsister’s foot into Cinderella’s pretty glass slipper. It doesn't fit without cutting off some essential parts. And in cutting off parts for the sake of beauty and precision, models inevitably mask the true risk rather than exposing it. The most important question about any financial model is how wrong it is likely to be, and how useful it is despite its assumptions. You must start with models and then overlay them with common sense and experience.

Many academics imagine that one beautiful day we will find the ‘right’ model. But there is no right model, because the world changes in response to the ones we use. Progress in financial modeling is fleeting and temporary. Markets change and newer models become necessary. Simple clear models with explicit assumptions about small numbers of variables are therefore the best way to leverage your intuition without deluding yourself.

All models sweep dirt under the rug. A good model makes the absence of the dirt visible. In this regard, we believe that the Black-Scholes model of options valuation, now often unjustly maligned, is a model for models; it is clear and robust. Clear, because it is based on true engineering; it tells you how to manufacture an option out of stocks and bonds and what that will cost you, under ideal dirt-free circumstances that it defines. Its method of valuation is analogous to figuring out the price of a can of fruit salad from the cost of fruit, sugar, labor and transportation. The world of markets doesn’t exactly match the ideal circumstances Black-Scholes requires, but the model is robust because it allows an intelligent trader to qualitatively adjust for those mismatches. You know what you are assuming when you use the model, and you know exactly what has been swept out of view.

Building financial models is challenging and worthwhile: you need to combine the qualitative and the quantitative, imagination and observation, art and science, all in the service of finding approximate patterns in the behavior of markets and securities. The greatest danger is the age-old sin of idolatry. Financial markets are alive but a model, however beautiful, is an artifice. No matter how hard you try, you will not be able to breathe life into it. To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules.

MODELERS OF ALL MARKETS, UNITE! You have nothing to lose but your illusions.

The Modelers' Hippocratic Oath

~ I will remember that I didn't make the world, and it doesn't satisfy my equations.

~ Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.

~ I will never sacrifice reality for elegance without explaining why I have done so.

~ Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.

~ I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.

       

Emanuel Derman and Paul Wilmott January 7 2009

Please join in the discussion of this Manifesto here.

A friend of mine, you may know him, you certainly know ‘of’ him, has called for the return of a couple of economics Nobel Prizes. It’s Nassim Nicholas Taleb, in case you didn’t know. (I mention his name because it may increase the number of times this blog is read thanks to Google!) I’m not fussed one way or the other whether or not they get to keep their prizes, I don’t really see much difference between their work and that of many of the others awarded the economics Nobel. (Yes, I know, it’s not a proper Nobel, blah, blah, blah, Bank of Sweden, blah, blah, we can take that much as read!) Or even those awarded the prize in other fields. The Nobel Prize for Literature seems to be political (political meaning either greasy pole, or as in politically correct), the Peace Prize is downright perverse, so the Economics Prize is no different for being pointless. In contrast, we probably all respect laureates in medicine, chemistry and physics for mostly decent work that has stood the test of time.

Economics is a queer subject. I like to boil things down to the very basics whenever I am trying to learn something new, doing research or teaching, as the students on the CQF can attest—think of some of my stranger analogies, guys! But this doesn’t work with economics. Starting with a couple of blokes in a cave, one of whom has just invented the wheel, try to imagine the exchanges that take place and how that turns into General Motors. No, it makes my brain hurt. No matter how much red wine I’ve drunk it doesn’t seem to work.

And I’m supposed to be clever. Why am I incapable of understanding economics, a straightforward enough subject that it’s even taught in schools?

My failure led me to think about economists, as opposed to economics, and they’re much easier to figure out. This is how it works. An economist starts with a few axioms, ones that bear a vague similarity to a small part of the human condition under restricted situations and in an idealized world. (You get my drift here?) From those axioms follows a theorem. More often than not this will be a theorem based upon rational behaviour. That theorem gets a name. And that’s the point I identify as being the problem: The jargonizing of complex ideas based upon irrelevant assumptions into an easily used and abused building block on which to build the edifice of nonsense that is modern economics.

Small assumption by small assumption, the economist builds up his theories into useless gibberish. By acceptance of each step he is able to kid himself he is making progress. And that’s why I struggle with economics. It is not mathematics where, barring mistakes, each step is true and indisputable and therefore you can accept it, even forget it, and move on. And others can do the same, using everyone else’s results without question. This you cannot do in a soft science. I’ve mentioned this in another blog, beware of anyone talking about ‘results’ in finance or economics, it says more about them and their perception of the world than it does about the subject.

Not so long ago Alan Greenspan famously said he had found a flaw in the “critical functioning structure that defines how the world works.” “I don't know how significant or permanent it is but I have been very distressed by that fact.” Ohmigod! His naivety and lack of self knowledge is staggering. He has fallen into the same trap as other economists. By believing the theories he has believed the axioms on which they are based. The edifice of nonsense has collapsed on top of one of its builders.

You beautiful, complex, irrational people! Please, promise me that you will continue to violate every axiom and assumption of economics, maybe not all the time, that would be too predictable, but now and then, just so as to keep those pesky economists on their toes!

Greenspan also said that risk models and econometric models are still too simple. Lord, help us!

Let me tell you a story.

A decade or so ago I was browsing through the library of Imperial College, London, when I happened upon a book called something like “The Treasury’s Model of the UK Economy.” It was about one inch thick and full of difference equations. Seven hundred and seventy of them, one for each of 770 incredibly important economic variables. There was an equation for the rate of inflation, one for the dollar-sterling exchange rate, others for each of the short-term and long-term interest rates, there was the price of fish, etc. etc. (The last one I made up. I hope.) Could that be a good model with reliable forecasts? Consider how many parameters must be needed, every one impossible to measure accurately, every one unstable. I can’t remember whether these were linear or non-linear difference equations, but every undergrad mathematician knows that you can get chaos with a single non-linear difference equation so think of the output you might get from 770. Putting myself in the mind of the Treasury economists I think “Hmm, maybe the results of the model are so bad that we need an extra variable. Yes, that’s it, if we can find the 771st equation then the model will finally be perfect.” No, gentlemen of the Treasury, that is not right. What you want to do is throw away all but the half dozen most important equations and then accept the inevitable, that the results won’t be perfect.

A short distance away on the same shelf was the model of the Venezuelan economy. This was a much thinner book with a mere 160 equations. Again I can imagine the Venezuelan economists saying to each other, “Amigos, one day we too will have as many equations as those British cabrones, no?” No, what you want to do is strip down the 160 equations you’ve got to the most important. In Venezuela maybe it’s just one equation, for the price of oil.

We don’t need more complex economics models. Nor do we need that fourteenth stochastic variable in finance. We need simplicity and robustness. We need to accept that the models of human behaviour will never be perfect. We need to accept all that, and then build in a nice safety margin in our forecasts, prices and measures of risk.

Happy New Year!

P

There are honest people, and there are dishonest people, a whole spectrum. I like to think I'm near the honest end, I would have worn a white hat in the old cowboy movies. And I've had the misfortune to have met a few from right up close to the other extreme, with the black hats. Most people wear hats of various shades of grey. High finance is a business which encourages people to shift towards the dishonest end of the spectrum by putting temptation in their way, and the dishonest are drawn to this field by its quick and easy rewards.

Nothing that I have ever seen in investment banking and fund management has impressed me as a disincentive to crooked behaviour, absolutely nothing.

As a keen observer of human behaviour I have been fascinated watching people's attitude towards money. In academia they struggle with their mixed feelings, on the one hand hating the filthy stuff since they are supposed to be above such worldly matters, but on the other hand rather liking what they can do with it. The really rich see it as nothing more than a measure of their success in life, a score. Some balanced people, few and far between, realise they need it, and that more is better than less, but it's not the main focus in their lives. Then there is the common greed that we see in our business, nasty and unpleasant. And nasty, unpleasant greed is so easy to feed, it is encouraged in banking, but it has some unpleasant side effects.

The Madoff affair has highlighted several things, brought some corrupt practices to light, but we haven't really learned anything new from all of this. The old lessons, the ones that should have been learned years ago, are just as valid. As I keep saying, there is little reason for regulators to do anything: People have short memories; People are easily distracted; The legal system is now much better at protecting the guilty than protecting the innocent.

Just like the Social Services in the UK, regulators do such a useless job that they are now permanently on the defensive. I bet you that few people working for regulators are doing their jobs right now, I bet most of their day is spent figuring out how to protect themselves against the growing backlash.

Quite frankly I don't see much difference between Madoff's Ponzi scheme and naive auditors, self-serving regulators and morally corrupt ratings agencies. They are all part of a financial system that encourages scams, scams that may then take years to sort out and years before the culprits are punished, meanwhile out on comfortable bail. The US legal system is particularly easy to 'play' so as to drag proceedings out so long that the accused dies of natural causes before justice is done.

There is no disincentive for dishonest behaviour in investment banking at the moment, in fact the opposite. If someone wants to invest with a manager they think might be dishonest but successful then they will ignore the dishonesty. If the investor loses their shirt then tough, serves them right. (Of course, it won't be their money, so anyone found not having done their full due diligence ought to be arrested.) I know of several people who manage money who have broken serious laws, lawbreaking that would prevent them managing money. And I know of some investors who know that I know, but who, when considering investing with these people, deliberately do not ask for my opinion as part of their due diligence. Why not? Because once they hear what I have to say then they would no longer be able to invest with the crooked, but oh-so-smooth and convincing manager. If you've ever bought a dodgy DVD at the market, or a hi-fi from a man in the pub, then you are just as culpable. And you therefore might find some sympathy for a lot of people being blamed at the moment. I haven't, and I don't.

When I first realised, several years ago, that due diligence is deliberately not being done I proposed that formal psychometric testing be part of the process of setting up a hedge fund or managing money. I know this is easy to criticize or trivialize, especially by all the 'left-brainers' working in finance. But equally I'm not a great fan of having to pass multiple-choice exams to get letters after your name showing how many regulations you know, I don't think this has much relevance today. But in this business trust is so important. In a world where we never get to know the people looking after our life savings, as we might have done in the old days, I can think of no other simple indicator of testing trustworthiness. Some people are dishonest, some can't be trusted. Do you care? I do, and always have. Maybe other people don't, that's greed at work, but they will eventually, perhaps only after they've lost lots and lots of money.

P

Quantitative finance and risk management are not just about the numbers. Numbers play a part, but so does the human side of the business. When analyzing risk it is important to be able to think creatively about scenarios. Unfortunately the training that most quants get seems to actively discourage creativity.

Some of the following appeared on the BBC website in December 2008.

We've learned the hard way how important it is to measure and manage risk. Despite the thousands of mathematics and science PhDs working in risk management nowadays we seem to be at greater financial and economic risk than ever before. To show you one important side of banking I'd like you to follow me in an exercise with parallels in risk management.

You are in the audience at a small, intimate theatre, watching a magic show. The magician hands a pack of cards to a random member of the audience, asks him to check that it's an ordinary pack, and would he please give it a shuffle. The magician turns to another member of the audience and asks her to name a card at random. "Ace of Hearts," she says. The magician covers his eyes, reaches out to the pack of cards, and after some fumbling around he pulls out a card. The question to you is what is the probability of the card being the Ace of Hearts?

Think about this question while I talk a bit about risk management. Feel free to interrupt me as soon as you have an answer. Oh, you already have an answer? What is that, one in fifty two, you say? On the grounds that there are 52 cards in an ordinary pack. It certainly is one answer. But aren't you missing something, possibly crucial, in the question? Ponder a bit more.

One aspect of risk management is that of 'scenario analysis.' Risk managers in banks have to consider possible future scenarios and the effects they will have on their bank's portfolio. Assign probabilities to each event and you can estimate the distribution of future profit and loss. Not unlike our exercise with the cards. Of course, this is only as useful as the number of scenarios you can think of.

You have another answer for me already? You'd forgotten that it was a magician pulling out the card. Well, yes, I can see that might make a difference. So your answer is now that it will be almost 100% that the card will be the Ace of Hearts, the magician is hardly going to get this trick wrong. Are you right? Well, think just a while longer while I tell you more about risk and its management.

Sometimes the impact of a scenario is quite easy to estimate. For example, if interest rates rise by 1% then the bank's portfolio will fall in value by so many hundreds of millions. But estimating the probability of that interest rate rise in the first case might be quite tricky. And more complex scenarios might not even be considered. What about the effects of combining rising interest rates, rising mortgage defaults and falling house prices in America? Hmm, it's rather looking like that scenario didn't get the appreciation it deserved.

Back to our magician friend. Are those the only two possible answers? Either one in 52 or 100%? Suppose that you had billions of dollars of hedge fund money riding on the outcome of this magic trick would you feel so confident in your answers? When I ask this question of finance people I usually get either the one in 52 answer or the 100%. Some will completely ignore the word 'magician,' hence the first answer. Some will say "I'm supposed to give the maths answer, aren't I? But because he's a magician he will certainly pick the Ace of Hearts." This is usually accompanied by an aren't-I-clever smile! Rather frighteningly, some people trained in the higher mathematics of risk management still don't see the second answer even after being told.

This is really a question about whether modern risk managers are capable of thinking beyond maths and formulas. Do they appreciate the human side of finance, the herding behaviour of people, the unintended consequences, what I think of as all the fun stuff. And this is a nice question because it very quickly sorts out different types of thinkers.

There is no correct answer to our magician problem. The exercise is to think of as many possibilities as you can. For example when I first heard this question an obvious answer to me was zero. There is no chance that the card is the Ace of Hearts. This trick is too simple for any professional magician. Maybe the trick is a small part of a larger effect, getting this part 'wrong' is designed to make a later feat more impressive...the Ace of Hearts is later found inside someone's pocket. Or maybe on the card are written the winning lottery numbers that are drawn randomly 15 minutes later on live TV. Or maybe the magician was Tommy Cooper. Or it was all the magician's performance-anxiety dream the night before. When I ask non mathematicians this is the sort of answer I get.

The answer one in 52 is almost the answer least likely to be correct! Magicians only rarely rely on probability. Clue: How many times did Houdini die during his Water Tiorture trick? (Unless the magician was using an ordinary deck of cards, was aiming to pull out a different card but accidentally pulled out the Ace of Hearts instead! Accidentally not making the intended 'mistake.')

A member of wilmott.com didn't believe me when I said how many people get stuck on the one in 52 answer, and can't see the 100% answer, never mind the more interesting answers. He wrote "I can't believe anyone (who has a masters/phd anyway) would actually say 1/52, and not consider that this is not...a random pick?" So he asked some of his colleagues the question, and his experience was the same as mine. He wrote "Ok I tried this question in the office (a maths postgraduate dept), the first guy took a fair bit of convincing that it wasn't 1/52 !, then the next person (a hardcore pure mathematician) declared it an un-interesting problem, once he realised that there was essentially a human element to the problem! Maybe you have a point!" Does that not send shivers down your spine, it does mine.

Once you start thinking outside the box of mathematical theories the possibilities are endless. And although a knowledge of advanced mathematics is important in modern finance I do rather miss the days when banking was populated by managers with degrees in History and who'd been leaders of the school debating team. A lot of mathematics is no substitute for a little bit of commonsense and an open mind.

How can we get quants and risk managers to think beyond the mathematics? I'm afraid I don't think we can, the way the majority of them are currently educated.

P

As you will no doubt know, I have been frustrated by quants for a long, long time. Their modelling of markets is a strange combination of the childishly naïve and the absurdly abstract.

On a one-to-one basis many people working in banks will complain to me about the models they have to implement. They will complain about instability of the Heston volatility model for example. I will explain to them why it is unstable, why they shouldn't be using it, what they can do that's better and they will respond along the lines of "I agree, but I don't have any choice in the matter." Senior quants are clearly insisting on implementations that those on the front line know are unworkable.

And a large number of people complain to me in private about what I have started calling the 'Measure Theory Police.' These 'Police' write papers filled with jargon, taking 30 pages to do what proper mathematicians could do in four pages. They won’t listen to commonsense unless it starts with 'Theorem,' contains a 'Proof,' and ends with a 'QED.' I'll write in detail about the Measure Theory Police at a later date, but in the meantime will all those people complaining to me about them please speak up...you are preaching to the converted, go spread the word!

For several years I tried to argue scientifically, in papers, book, seminars, etc. about all the abysmal modelling I saw. Of all the conferences that I speak at, you would think that quant events would be the ones at which the audience would have the best appreciation of good versus bad modelling. Frustratingly, quant conferences have audiences with great technical skills but the least imagination. If you're not lecturing about the wonders of correlation, but about the stupidity of correlation, then expect a hostile ride. But I battled on, I have a very tough skin!

Then I thought I'd try a different tack. If data, scientific explanations and commonsense won't get the truth across then something else was required. (It turns out that the 'something else' was losses of trillions of dollars and a global recession!)

So I started introducing audiences to relevant aspects of human psychology. I explained about the famous experiments in peer pressure to highlight why people were adopting the same models as everyone else. I explained about the famous experiments in diffusion of responsibility, mentioned recently in an article by Taleb and Triana, so that people would understand why they were sitting around not doing anything about the terrible state of affairs. Perhaps a little bit of cognitive behavioural therapy might help them understand their own motives and this would bring about a change of practice in finance. Of course, I was overambitious. Audiences were entertained and amused, a good time was had by all. And then they went back to their day jobs and the implementation of the same old copula nonsense.

Combine peer pressure with diffusion of responsibility and fear for their jobs and most people will keep quiet. Sad, but expected and, reluctantly I will admit, understandable.

What is not understandable is the role in recent events played by regulators and rating agencies. Their jobs are not to toe the party line. The job of the regulator is to hold up the yellow card to banks with bad practices and the job of the rating agencies is to give an honest assessment of creditworthiness. In neither case should they have been effectively colluding with banks in increasing the amount of risk taken.

I have an analogy for you.

A rating agency or a regulator visits a bank. They are being shown around the premises, looking at all the products they have and how they are managed. They come to one desk on which there is a pile of nuclear material. "That's a large pile of nuclear material. How much does it weigh?" they ask. "Oh, nothing to worry about, only half the critical mass," comes the reply. They go on to the next desk and see a similar pile. "Nothing to worry about, only half the critical mass." They go next door to another bank, and they see the same story. It doesn't take a genius to see the potential risks. The regulators and the credit rating agencies saw something similar, with CDOs and the like being the explosive material.

In the early days of the current crisis the talk was of blame. That was precisely the wrong thing to consider at that time. Shore up the financial system asap, that was the most important thing to do. A quick response was what mattered, the details didn't. Now is the time to start considering blame and punishment. And yes, there has to be punishment. You cannot have obscene rewards for those working in banking, salaries tens or hundreds of times the national averages without expecting and demanding corresponding responsible behaviour. It is both morally objectionable and financially dangerous to not have the huge upside balanced by a matching downside for irresponsible actions. And so I point the finger at rating agencies and regulators as those near the top of those who must take the blame.

Realistically I expect further frustration and a return to business as usual.

P

We are curious to find out about the personality types working within quantitative finance, risk management, development, etc. So we'd like you to tell us your type!

Take the test here http://www.humanmetrics.com/cgi-win/JTypes2.asp, it will only take 5 minutes. When you've finished return to us here http://www.wilmott.com/mbti.cfm and put your result in the box. (You must be logged on to wilmott.com.)

Thanks for your help! We will report the results (keeping you anonymous, of course!) as soon as we have sufficient data.

About Myers-Briggs: According to wikipedia, the Myers-Briggs Type Indicator (MBTI) assessment is a psychometric questionnaire designed to measure psychological preferences in how people perceive the world and make decisions.

For a decade New Labour has manipulated the electorate by inflating the public sector, notoriously full of Labour voters. Since 1997 two thirds of new jobs have been in the public as opposed to the private sector.

Now New Labour finds itself in a bit of a pickle. The economy is in recession, borrowing is at levels never seen before, job losses increasing, and fair-weather New Labour is completely out of ideas. Clearly they have no clue about what to do. The world economy is such that 'no growth' is apparently not an option. With everyone (except me) up to their eyebrows in debt the only way to survive is to keep spending. Running is the new standing still.

Gordon Brown's plan to increase such spending is a pathetic reduction in sales tax. At a time when shops are discounting by 50%, it is clear that another couple of percent off prices is not going to make a blind bit of difference.

However, it is perfectly possible, thanks to the enlarged public sector that New Labour will get back in at the next election. This thought frightens me. But I am not alone...

Back to New Labour's pickle.

The thought of New Labour winning the next election also frightens Gordon Brown. Can't you see what he is signalling with his sales tax reduction? He is saying "We haven't a clue what to do, don't vote for us." Can't you see what he is saying by threatening to increase taxes in two years' time? "Vote for us and you'll be sorry." No government tells you what they will do to taxes in two years' time. The present government doesn't even know what is going on under their noses at the present time, let alone where the UK economy will be in two years.

Guys, read between the lines here. Gordon Brown is saying to you "Please don't vote for us." New Labour is tired, their lucky break of being in charge of the UK just at the same time as the economy of the entire world was doing well is over. They want a break from government. They want to be in opposition, let the Tories sort out the mess the UK is in.

So, please take Gordon's hint. Do the man, and the rest of the country, a favour. When you get the chance to vote, vote Tory. It's what Labour really, really want you to do.

P

The following article was written in August 2008 for The Actuary magazine. I was reminded of it by the responses to our Name and Shame Blame Game.

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Those working in the two fields of actuarial science and quantitative finance have not always been totally appreciative of each others’ skills. Actuaries have been dealing with randomness and risk in finance for centuries. Quants are the relative newcomers, with all their fancy stochastic mathematics. Rather annoyingly for actuaries, quants come along late in the game and thanks to one piece of insight in the early ‘70s completely change the face of the valuation of risk. The insight I refer to is the concept of dynamic hedging, first published by Black, Scholes and Merton in 1973. Before 1973 derivatives were being valued using the “actuarial method,” i.e. in a sense relying, as actuaries always have, on the Central Limit Theorem. Since 1973 and the publication of the famous papers, all that has been made redundant. Quants have ruled the financial roost.

But this might just be the time for actuaries to fight back.

I am putting the finishing touches to this article a few days after the first anniversary of the “day that quant died.” In early August 2007 a number of high-profile and previously successful quantitative hedge funds suffered large losses. People said that their models “just stopped working.” The year since has been occupied with a lot of soul searching by quants, how could this happen when they’ve got such incredible models?

In my view the main reason why quantitative finance is in a mess is because of complexity and obscurity. Quants are making their models increasingly complicated, in the belief that they are making improvements. This is not the case. More often than not each ‘improvement’ is a step backwards. If this were a proper hard science then there would be a reason for trying to perfect models. But finance is not a hard science, one in which you can conduct experiments for which the results are repeatable. Finance, thanks to it being underpinned by human beings and their wonderfully irrational behaviour, is forever changing. It is therefore much better to focus your attention on making the models robust and transparent rather than ever more intricate. As I mentioned in a recent wilmott.com blog, there is a maths sweet spot in quant finance. The models should not be too elementary so as to make it impossible to invent new structured products, but nor should they be so abstract as to be easily misunderstood by all except their inventor (and sometimes even by him), with the obvious and financially dangerous consequences. I teach on the Certificate in Quantitative Finance and in that our goal is to make quant finance practical, understandable and, above all, safe.

When banks sell a contract they do so assuming that it is going to make a profit. They use their complex models, with sophisticated numerical solutions, to come up with the perfect value. Having gone to all that effort for that contract they then throw it into the same pot as all the others and risk manage en masse. The funny thing is that they never know whether each individual contract has “washed its own face.” Sure they know whether the pot has made money, their bonus is tied to it. But each contract? It makes good sense to risk manage all contracts together but it doesn’t make sense to go to such obsessive detail in valuation when ultimately it’s the portfolio that makes money, especially when the basic models are so dodgy. The theory of quant finance and the practice diverge. Money is made by portfolios, not by individual contracts.

In other words, quants make money from the Central Limit Theorem, just like actuaries, it’s just that quants are loath to admit it! Ironic.

It’s about time that actuaries got more involved in quantitative finance. They could bring some common sense back into this field. We need models which people can understand and a greater respect for risk. Actuaries and quants have complementary skill sets. What high finance needs now are precisely those skills that actuaries have, a deep understanding of statistics, an historical perspective, and a willingness to work with data.

A couple of years ago, at the dinner after one of the courses I teach with Nassim Taleb, I asked the multicultural group of delegates a question that I'd been thinking about and suspected I knew the answer to. Or rather I suspected I knew what certain people's answers would be, the correct answer I still don't know. The question was "How many different types of cheese are there in the world?"

Now when I just said that I suspected I knew what certain people would say, those certain people are Americans. Around the table were folk from all over Europe, Australia, one from Iceland, and some Americans. So I asked the question of one of the Americans. He did not disappoint, and he gave the answer that I expected, but feared. His answer was "Seven or eight."

Had I asked for the names of the seven or eight I would probably have got the answer "Cheez Wiz, cheese slices,...and Monterey Jack." If you are from Europe you will have a better idea of the correct answer, which I suspect is in the thousands.

Now I love America and Americans so much that I married one. But the uniformity of the tastes of this large, rich country, or any, large, rich country, has the potential to damage smaller producers of niche products. Combine uniform tastes with easy global transport and hypermarkets within reach of everyone and you've got a recipe for evolution towards blandness. We are told that French wines are suffering from globalization. But then we also hear about record years for French wines. So what is happening?

Timescales are very important here, and we have the competing effects of globalization on the one hand and education on the other, together with the natural timescale for businesses to grow or collapse. Which will win?

It would be a shame if cheese or wine were to suffer, since I fully intend my retirement years to be spent sitting by a pool, somewhere warm, catching up on my reading, while working my way through the wines and cheeses of the world!

Finally, a question for you, how many varieties of apple are there? (Not that I care much for fruit or veg, where I come from chips count as one of my five portions per day!)

P

Word on the street and common sense suggest the following short- and medium-term future for hedge funds:

1) On average hedge funds will probably have done not much better or worse than the market as a whole. However, that average performance will hide a lot of extremes. Many funds, thanks to lady luck and leverage will be up record amounts. But that means many funds will be down record amounts too, and the downside is severely limited by zero! Therefore expect to see many funds announcing blow ups soon, maybe 30% of funds will close up shop for one reason or another.

2) After the blow ups expect to see the lawsuits. There will be many managers who have broken the terms of their prospectuses, many will have taken risks that they ought not to have taken. If they made money then they'll get away with it, if they've lost money then they will be on the wrong end of suits for damages. (Not that there's ever really a right end of a lawsuit!) And there will also be opportunistic suits in cases where no wrong has been done. In the US anybody can sue anyone for anything remember. There will be a three- to six-month delay between the big losses and the big lawsuits. They will take many years before they are completed.

3) When the dust has settled expect to see small, boutique funds being popular. They will have managers with very specialised experience and they will work closely with investors. There will necessarily be more transparency. Because investors will have the upper hand in negotiations leading up to investments expect to see investors taking a shareholding in hedge funds.

The above is what probably will happen. Now for something I personally would like to see happen.

For several years now I have been advising that potential investors in funds really need to take their due diligence far more seriously than they do at the moment. Current practice is that if an investor is very keen on a particular fund, perhaps because of a very persuasive salesman, then they tend not to perform as many background checks as they ought. The reason is simple, if they do the checks then they might find something that means they are unable to invest, therefore they reckon it's better if they don't do the checks. This leaves them the freedom to invest where they want. This is naive and dangerous.

In any random walk through life one encounters people who should not be left in charge of a pair of scissors never mind billions of dollars. These are people who, following formative experiences, are excessively risk seeking, or panic in a crisis, or who have a false idea of their own talents or who are simply dishonest. You may be unlucky enough to meet one person with all of these characteristics! Put this person in a sharp suit, send them to how-to-be-a-fund-manager finishing school and, hey presto, you’ve got a front-page Wall Street Journal scandal. There are a lot of clever people out there, people of talent, but how can you tell them from the disasters in waiting? I would very strongly advise that investors take the background checking far more seriously than at present. Speak to managers' colleagues, partners in previous funds, previous employers and previous employees, etc. Double and triple check CVs and qualifications.

I doubt whether it will catch on, sadly, but I’ve also been advocating for years that there should be a process of psychometric testing, along the line of Myers-Briggs, for fund managers. This is actually not uncommon in other business scenarios involving large loans, buyouts, etc. and ought to be standard practice for any position of serious responsibility.

P

Yesterday I was speaking at a hedge fund conference. On a discussion panel with me were some very eminent hedge fund managers. When asked their returns all of them said ten, 15, 20 percent this year. Perfectly normal numbers. It seemed strange to hear such normal numbers at a time of such abnormal markets.

Maybe that was because the specially picked panel was made up of sensible and respectable managers, those who would do well, and importantly, act conservatively, whatever the state of the markets.

But such managers are unfortunately rather rare.

While highly regulated banks can collapse any day of the month, hedge funds tend to report their perform