Myron Scholes predicts 'golden age' for quants

http://www.risk.net/risk-magazine/news/2103622/myron-scholes-predicts-golden-age-quants

Top quant sees bright future for mathematical finance as it tackles problems thrown up by the crisis

A top quantitative analyst and economics Nobel laureate says the coming years will be a "golden age" for financial modelling as it tackles problems highlighted by the global financial crisis – particularly relating to liquidity, intermediation and the role of the state.

Myron Scholes, emeritus professor of finance at Stanford University and co-creator of the Black-Scholes option pricing formula, says that because the fundamental assumptions of dominant pre-crisis theory have been challenged, many lines of research are now open to exploration.
"I'm bullish on the future for quants," he says. "One thing about a crisis is that it shakes old opinions and you start learning new things. I hope we do – it should be a golden age for risk modelling and management."

I'm very bullish on the future for quants - it should be a golden age for risk modelling and management

In particular, Scholes singles out the returns from market-making and client business – a concept he dubs 'omega' – as an area in which quants can add value. "The most important thing in the coming years will be intermediation – and modelling is a big part of that. How much capital do we want against a given strategy? What kind of capital structure should we have? How can we risk-manage dynamically, taking account of changes in the risk factors, changes in the risk appetite, the cost of adjusting the portfolio?

"The effect of intermediation is to correct prices, so it brings mean reversion into the processes – which one can attempt to capture with models. The idea is that you have a belief in where prices are going to revert to, and how fast they will do so, and this determines strategy. For example, if you have a lot of volatility you might want to go into your position sooner because mean reversion might occur more quickly," he says.

However, he warns against overreliance on models, and concedes they had a role in the crisis. The example he uses is the 'gaming' of structured credit ratings, through which issuers did the bare minimum required to obtain a AAA-rating.

"The rating agencies' model became an inventory transition mechanism. Their models did not take account of the fact that others would reverse-engineer their assumptions and place just enough good mortgages in the pool to achieve the desired rating. They didn't realise people would figure out how to make the AAA grade and game them.

"One of the problems we have is that we have to make assumptions about what the equilibrium will be and how that changes dynamically. You look at the economics – the capital flows in the market that determine the dynamics. That's where the expertise comes in – your technology shouldn't be a black box," he says.

But the common-sense reaction – embracing intuition, and rejecting the use of modelling and quantitative techniques – is also flawed, he argues.

"A model is a description of reality, so if it doesn't reflect reality then it's not going to work. If you think the model error is basically second-order and it's not, then the terms you neglected are going to come to the fore and the model will fail. That doesn't mean you're going to do any better with intuition – presumably you used your intuition in picking the model, and intuition can fail, too," he says.

An interview with Scholes, in which he discusses this issue at greater length, as well as how changes in regulation will affect markets, the computational limits of quantitative finance and the collapse of his hedge fund, Long Term Capital Management, will appear in the September issue of Risk.
 
but the things is the market is so volatile right now, quants are having a tough time and are getting blamed for almost everything. In a few years i believe then we will have the technological knowledge on how to make money when everything is up and down
 
Ha! True story - about two months ago a family friend asked me what I was up to. When I replied that I was attending Baruch College's MFE program he got all offended. He started going on about how the entire financial crisis is fault of the quants and advised me to tell people I'm in "Business". :D

I'm assuming he got fired and needed someone other than himself to blame it on. He probably read "The Quants" as well...
 
Ha! True story - about two months ago a family friend asked me what I was up to. When I replied that I was attending Baruch College's MFE program he got all offended. He started going on about how the entire financial crisis is fault of the quants and advised me to tell people I'm in "business". :D

I'm assuming he got fired an needed someone other than himself to blame it on. He probably read "The Quants" as well...

His anger is not in resistance with your opinion that - "We, quants are angels without wings". Once I spoke about the importance of quantitative analysts and I repeat that quantitative models (when attainable) are most precious pictures of reality in contrast with qualitative delirium. That one word for your quantitative inspiration.

But I remember Myron Scholes, Robert Merton and Paul Wilmott talking about quants' faults and their "big contribution" in LTCM crisis. So I think the ideas: "Quants will take a lead role in stabilizing financial world" and "They are to be blamed for crisis" are not incompatible.
 
I am looking forward to what Myron has to say about the LTCM crisis. My take is that they had collateral agreements with many banks so they could leverage their positions to the hilt. Each bank only saw their position vs. LTCM, not their positions with other banks or the rest of their portfolio. I think the NY Fed did the right thing by handing the banks the LTCM positions to unwind.
 

alain

Older and Wiser
I am looking forward to what Myron has to say about the LTCM crisis. My take is that they had collateral agreements with many banks so they could leverage their positions to the hilt. Each bank only saw their position vs. LTCM, not their positions with other banks or the rest of their portfolio. I think the NY Fed did the right thing by handing the banks the LTCM positions to unwind.

Myron Scholes has fielded this question multiple times. If you google for it, you will probably find his response.

Also, read the book about LTCM (When genius failed). Scholes had very little to do with the investment strategies at LTCM.
 
I don't have a lot of faith in getting a true story from journalists. Remember Fiasco: The Inside Story of a Wall Street Trader? I worked closely with a member of that group and Partnoy's portrail is anything but accurate. Book authors are in the business of selling books. Why bother with the boring truth when you can tell a juicy story that sells?

Having said that, I found Too Big to Fail by Sorkin to be well researched and thoughtful. I learned a lot of facts I had not heard before from that book.

I find as people get older they tend be more open about what really went down. If it is okay with you, I'm still going to look forward to what Myron has to say. There is nothing like hearing things straight from the horse's mouth. Especially a wise old horse.

I am sure you are trying to be helpful, but you are coming off as a litte arrogant. Do you really think telling someone to go Google is adding value?
 

alain

Older and Wiser
I don't have a lot of faith in getting a true story from journalists. Remember Fiasco: The Inside Story of a Wall Street Trader? I worked closely with a member of that group and Partnoy's portrail is anything but accurate. Book authors are in the business of selling books. Why bother with the boring truth when you can tell a juicy story that sells?

You might be right. However, my old boss worked at LTCM. He pretty much comfirmed what I said.

I am sure you are trying to be helpful, but you are coming off as a litte arrogant.

If I sounded arrogant, I'm really sorry for it. I just made the comment with the best intentions. If you think that is arrogant... I don't know what to say.

Do you really think telling someone to go Google is adding value?

In this case, yes. I think a lot of people will just take that comment as an advice and try to do a search.

I was at CSFB in 2003 when Myron Scholes gave a talk about some topic (don't remember but it is irrelevant). The first question in the QA was "What did you learn from LTCM?. So, he has probably answered this question multiple times.
 
I'm guessing he is writing the article because he thinks he has something more to say on the topic. Now you are definitely sounding arrogant, but there is no need to apologize this time. Other people need your help and I can manage to tough it out on my own. Thanks!
 
Myron Scholes came to Kent State in the fall of 2009. The MSFE students and PhD students were given the opportunity to attend a private talk with him that lasted about an hour. At the end of the talk, he fielded questions from the room. I asked, "What do you think is the single most important area of research right now in finance?" He gave an answer that took about two minutes, but to sum things up, it can best be stated as: We need to understand liquidity much better than we currently do.
 
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