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These models can be very complex for most people, but a trader does not need to control the types of financial engineering to understand the situation of his trading house and decide. For our trader, even if chance cannot be predicted or controlled, it is no less evocative. Mathematical models can be brilliant, but the more they are, the more they may tend to model the world as we would like it to be. In fact, the problem is not as mathematical models, but how we use it.
The objective of quants is to avoid future financial crises by “quantifying” human behavior in economics and leaving aside the hazard and randomness. And yes, with Quants human behavior is deterministic in the markets and the market is not random!
You knew the reign of financial mathematical models based on random data, you liked the Monte Carlo simulation. Now all this according to the Quants, belongs to the conventional academic environment! Today, the real world are the quants and their robots.
But the problem of quants is not only a problem of robots. We believe, indeed, that their work almost always lead to systematic underestimation of rare events or designated as extreme.
But we can say generally that it is still often assumed that the statistical and probabilistic Gaussian environment (referring to the normal Laplace-Gauss) is adorned with all virtues in the world of modern finance.
– banks and investment banking (CIB) were supposed to perfectly control their market risks with a “magic” tool called Value at Risk. We see instead that in times of stress no one have control over anything;
– asset management subsidiaries of these banks were supposed to optimally manage the savings surplus of individual and institutional investors;
– Finally, economic agents could hedge their financial risks from the CIB through the use of derivatives perfectly priced.
From a technical standpoint, the Black and Scholes formula to evaluate the price of some of these products could give scientific legitimacy to the new environment. And for top management, simplicity and speed of calculation are the arguments against which no one, or almost, can fight: after all it was it is just to know how to integrate a differential equation (sorry for non-mathematicians); efficient computing capacity and therefore not weighing too heavily on bank operating ratios.
1/ To the world leader, this unanimist type of modeling is ideal since mathematics (at least some use of them) allow to self-persuade that major disasters are almost impossible
2/ Then minimizing extreme risks enable to continue to fund waste and excess debt that led to bubbles. There is behind this two types of findings: often the greed of some institutions highly paid to sell financial products whose risk is clearly undervalued, but also the need to justify the waste of our bloated and incompetent bureaucracies. All this to ensure continued funding of public deficits, which leads to universally consider that the overvaluation of governments debt under scrutiny is not considered risky (which is false)
3/ The minimization of risks by the quants also legitimate a model of development:
– That of abnormally high profitability standards in terms of economic fundamentals (again greed and profit inefficiently reused)
– There is also the financial engineering of banks aiming to transfer risk on some private economic agents to save capital and improve again and again the return on equity employed.
What should we do?
First, we must continue to invest in research to improve mathematical modeling (which will always include deficiencies by construction).
One thing is certain: it will never be possible to model fear, mimicry and even less the impact of regulatory, prudential and accounting on investor behavior. But it is the understanding of these phenomena that can help managing and apprehending “modern” finance crises.
In total for us, the quants symbolize greed, fear and the randomness and obscure Wall Street. Certainly they were called to order by the securities and exchange commission, but do you seriously believe that things are different today?
There is no shame to accept uncertainty and randomness of this world. We believe that the simple recognition that uncertainty is inevitable is already changing things in a fundamental way. However, this recognition must be genuine by overcoming our aversion to uncertainty. We must learn to take the uncertainty and ambiguity in trade and remember that it is not a science but an art.
We are for intelligent uses of mathematics in finance and not by setting equation of human behavior. Because the human charm is to surprise its environment and for that he has no need of robots transmitting price instructions, at the speed of light, for example. Because it will be very difficult or impossible to control such systems. Experience it tonight in your car, change the instructions of your air conditioner, not at the speed of light, but let’s say every 3 or 4 seconds (select 17 °, then 3 seconds after 23 °, then after 3 seconds 19 ° and 27 °, …) and tell us what is the temperature inside your vehicle after 10 minutes (which is “relatively a small play” in relation to a day in a trading room with robots that transmit financial instructions at the speed of light)
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