This Christmas, a bevy of elegant models are on display. Not the long-legged female variety, instead regulators, bankers and investors have been flaunting their own smart models, as they seek to predict what 2011 might deliver.
But as this economic catwalk gets under way, it is shot through with irony. When the financial crisis hit, many observers blamed the disaster on the misuse of financial models. Not only had these flashy computer systems failed to forecast behaviour in, say, the subprime mortgage world, but they had also seduced bankers and investors to take foolhardy risks. These days, in spite of all those missteps, there is little sign that financiers are falling out of love with those models. On the contrary, if you flick through the recent plethora of reports from the Basel Committees – or look at the 2011 forecasts emanating from investment banks – these remain heavily reliant on ever-more complex forms of modelling.
So what are investors to make of this? One particularly thought-provoking set of ideas can be seen in the current work of Emanuel Derman, a former physicist-turned banker who shot to fame within the banking industry two decades ago by co-developing some path-breaking financial models, such as the Black-Derman-Toy model (one of the first interest-rate models) and the Derman-Kani local volatility model (the first model consistent with the volatility smile.)*