Tuesday, March 10, 2009

Quants and the Limits of Certainty

. Tuesday, March 10, 2009

Quants, those lovable braniac physicists-cum-financial forecasting gods, sure are taking a beating in the race to "uncover" the reasons behind the global financial crisis.  From David Li's copula to the unrealistic assumptions that underlie the Black-Scholes model of equity options, the news media seems keen to tell a story of smart guys whose propensity for abstract thinking rendered their models useless and even dangerous for any applied usage.

The New York Times has an excellent article today about the species that is the quant analyst.  Importantly, the article seems to draw a parallel between quants and other scientists whose work was used in controversial ways (read Manhattan Project).  Quants might not be the bad guys after all, but merely cogs in the wheels of CEOs engines of economic disaster.  In fact, it does seem important to emphasize that many quants knew the limitations of their models and tried to warn upper management about those limits.

The fact that those warnings went unheeded, however, leads to interesting questions about the role of regulation in financial markets.  As quantitative analysis expands the ways in which investment houses try to make money, and as increased correlation means the consequences for bad bets grows in breadth and depth, again the question becomes "should governments regulate the mechanisms by which financial institutions measure risk, and if so, how?".


Quants and the Limits of Certainty




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