Risk, Models, Intelligence – more

(Econ posts so far in this series without video clips pdf , also just realised Nerds on Wall Street is incorrect link in pdf too)

“We do need models and mathematics – you cannot think about finance and economics without them – but one must never forget that models are not the world. Whenever we make a model of something involving human beings, we are trying to force the ugly stepsister’s foot into Cinderella’s pretty glass slipper. It doesn’t fit without cutting off some essential parts. And in cutting off parts for the sake of beauty and precision, models inevitably mask the true risk rather than exposing it. The most important question about any financial model is how wrong it is likely to be, and how useful it is despite its assumptions. You must start with models and then overlay them with common sense and experience.”1

Not just mathematics, many financial and economic models have used principles taken from physics and other sciences  in the methods of calculations, the different ways of processing variables and the different methods of information presentation and visualization. They do not represent the world of human beings and organizations as a whole because they cannot present all the conditions that could occur, even using technologies for assistance. Emanuel Derman continued this theme from the manifesto at the Economic Manhattan project – saying that a distinction between the observable and non-observable is necessary, the limitations of forecasting in terms of human variables and value 2

In market structures, everything is relative – in markets it is not possible for everyone to be as successful as everyone else – so can intelligence be ‘engineered’ into market data and change their fundamental dynamics?

For Bank A, not knowing the links in the chain means that judging the default
prospects of Bank B becomes a lottery. Indeed, in some ways it is worse than a
lottery, whose odds are at least known. In this example, Bank A faces uncertainty in
the Knightian sense, as distinct from risk, about the true network structure.
Counterparty risk is not just unknown; it is almost unknowable. And the higher the
dimensionality of the network, the greater that uncertainty.

Just looking at how this video is marketed …”so you can profit”. Maybe it is not as simple as problem solving – there are more issues to be looked at in terms of cultural adjustment at the high-end of the financial sector, knowledge and uncertainty need further analysis as well as the psychological impact at a micro and macro-level of loss of profits / lower returns on investment etc

Do we just need to fix financial engineering then? Can we explain exactly what values are, what we consider to be uncertain and what types of risk we are likely to be comfortable taking? If we all as individuals make these decisions in isolation then that would be great. But what does the world look like now financially – its impossible to visualize all the financial interactions of every human at one moment in time. We may be able to generate models with increasing complexity, we may also be able to code in apparent randomness or the technology can do this.

But we are not starting from zero or a blank slate in 2009. E.g. if we want to invest in loans for social enterprises or micro-finance or micro-insurance, we could do this individually but at some point it is going to involve transactions through a banking  system. If someone needs a loan they need to get it from someone who has wealth and where has the someone got their wealth from – we can’t visualize yet – our 2 cent needle and the multi-trillion derivative-sized haystack. So it is uncertain at a micro and macro level, examples of which can also been seen in recent banking failures e.g

“For Bank A, not knowing the links in the chain means that judging the default prospects of Bank B becomes a lottery. Indeed, in some ways it is worse than a lottery, whose odds are at least known. In this example, Bank A faces uncertainty in the Knightian sense, as distinct from risk, about the true network structure. Counterparty risk is not just unknown; it is almost unknowable. And the higher the dimensionality of the network, the greater that uncertainty.”3

Tomorrow’s post will return to decision making and values.

1. Wilmott P, Derman E (2009), Financial Modelers Manifesto, Wilmott.com, available at http://www.wilmott.com/blogs/paul/index.cfm/2009/1/8/Financial-Modelers-Manifesto

2. Derman E (2009), Scientists, Sciensters, Anti-Scientists and Economists, Economic Manhattan Project, available at
http://streamer.perimeterinstitute.ca/Flash/afa2290d-2a19-46b8-8dcf-c2fbc86a0a17/viewer.html
3. Haldane A (2009) p15, Rethinking the Financial Network, Bank of England, available at http://www.bankofengland.co.uk/publications/speeches/2009/speech386.pdf

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