Wilmott and Derman: Financial Models Must Be Clean and Simple

Andy Nguyen

Whenever we make a mathematical model of something involving human beings, we are forcing the ugly stepsister's foot into Cinderella's pretty glass slipper. It won't fit without sawing off some essential parts. Trimmed for simplicity or beauty, models inevitably mask risk rather than expose it.

At bottom, financial models are tools for approximate thinking, a way to help transform one's intuition about the future into a price for a security today. The key word here is approximate. The most important questions about any model are: "What does it ignore, and how wrong is it likely to be?"

Financial modeling hit Wall Street big-time back in the 1970s when listed equity options markets opened in Chicago and interest rates soared after the U.S. dollar went off the gold standard. The growing options market created demand on Wall Street for "rocket scientists," as we quants were then called (in the mistaken assumption that rocketry was the cutting edge of physics). Our mission was to manage and hedge risks with models and the computer programs that used them

Financial Models Must Be Clean and Simple - BusinessWeek