Emanuel Derman

Dog’s Lives

Emanuel Derman
Aug 5, 2012 17:49 UTC







The perils of pragmamorphism

Emanuel Derman
Sep 23, 2011 14:57 UTC




Dystopic finance

Emanuel Derman
Sep 8, 2011 11:54 UTC

For a couple of years now I’ve had a bad feeling about the field of finance. Though I often inveighed against the mechanical use of models, I didn’t damn the entire endeavor. I still don’t, but the other day, talking to a colleague who was much younger than me, I discovered that we had somewhat similar sentiments. Mine are summarized as follows. I hope it’s just a mood.

Neoclassical finance, the entire structure that includes the efficient market model, Brownian motion, stochastic calculus, the capital asset pricing model, and of course Black-Scholes-Merton, is a beautiful comprehensive far-reaching discipline. It describes a risky system and its consequences elegantly and sparely, and provides lots of insight. I like it. Unfortunately, the real world is more complicated.

One of the responses to that complexity is behavioral finance. This started out with prospect theory as an attempt to provide a comprehensive new foundation for finance and economics. It hasn’t turned out that way. That part of behavioral finance is by and large ignored. Instead, its proponents have streamed off into two directions. The first is neuro/psycho finance, filled with papers discussing brain scans of traders and their risk appetite, which isn’t really finance at all, but belongs (if it belongs anywhere outside of grant applications) in a psychology department. The second is the study of how people react to choice, a collection of mildly interesting statistical studies of CEOs and investors that mostly confirm what everyone knew before, and whose results are most useful in justifying various paternalistic social policies. None of it adds up to a comprehensive discipline; it seems to be mostly strategies for writing papers.