Woodwork not research October 28, 2010 at 6:06 am

Is all quantitative financial risk management bunk?

No. Next.

OK, I will honour this idiotic question with a more detailed reply than it deserves.

Quantiative financial risk management is not an attempt to understand the fundamental dynamics of the market. It does not pretend to model the world they way that physics does. It simply aims to provide a set of tools which are useful in managing financial risk. Risk management, as she is practiced, is like woodwork: you want a table, we’ll make you a table to fit your budget. If you’re cheap, it might not look pretty. It certainly won’t bear the weight of an elephant. But you will be able to sit around it and eat dinner.

No one believes that Black-Scholes is right, for instance. If it were, there would be a single implied vol for every strike and maturity, and that vol would not vary from day to day. But Black-Scholes is a useful tool for managing options risk. Like a good carpenter, we deal with the issues by shaving a bit off here and bashing it into shape there. The result is, 99.9% of the time, useful. Things go wrong when the results of this process are used outside their domain of applicability. Don’t try to sit a pachyderm on a charity shop* table and you won’t hear splintering sounds.

*Thrift store for my American readers.

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