A Book Review: Models.Behaving.Badly. By Emanuel Derman

One of the wonders of Twitter is the people you meet.

You can write the tool off as talk, talk but it’s been a wonderful window to new worlds for me. People I would have never imagined knowing are in my life because we can gauge common interests passively. Which interests you reveal are entirely of your own choosing.

One of those people I now know but never could have imagined ever having the knowledge of, much less the pleasure of meeting, is Emanuel Derman.

He’s a character, a Saul Bellow character, said one writer when reviewing his first book:

That sense of being an intruder in outlaw territory lends an intriguing mood to Derman’sMy Life As a Quant, a literate and entertaining memoir of his two-stage career — in physics and then financial engineering. Wall Street looks quite different from a nerd’s-eye view: “Geeks were fair game,” Derman reflects. Once, a chief trader who passed between him and a fellow quant “winced, clutched his head with both hands as though in excruciating pain, and exclaimed, ‘Aaarrggh-hhh! The force field! It’s too intense! Let me out of the way!”‘

As one of Wall Street’s leading quants, Derman did throw off some intense gamma radiation. He worked at Goldman from 1985 until 2003 except for one year at Salomon Brothers. At Goldman, he moved from fixed income to equity derivatives to risk management, becoming a managing director in 1997. He co-invented a tool for pricing options on Treasury bonds, working with Goldman colleagues Bill Toy and the late Fischer Black, who co-invented the Black-Scholes formula for valuing options on stocks. Derman received the industry’s “Financial Engineer of the Year” award in 2000. Now he directs the financial-engineering program at Columbia University.

I had the opportunity to have dinner with Derman when he was in Chicago last week. Coincidentally – or not – it was the same day I posted my review of his new book at Forbes.com. Carl Jung says there’s no such thing as coincidence, only synchronicity – the experience of events which are causally unrelated, and yet their occurring together carries meaning to the person observing the events.

More than a description of what went wrong with models during the financial crisis, Derman describes what’s gone wrong with the use of them by those who infused models with omniscience. Derman says, “You can be disappointed only if you had hoped and desired. To have hoped means to have had preconceptions – models, in short – for how the world should evolve.”

The book starts by explaining the tragic social construct that Derman lived with as a child: apartheid in South Africa. “Racial classification was a tortuous attempt to impose a flawed model on unruly reality.”

An extensive biographical sketch of his childhood and youth in Cape Town, son of Jews who fled Poland in the mid-30’s ahead of the Holocaust, serves as an introduction to financial models and the crisis. Many of Derman’s extended family, including his maternal grandparents, were not as fortunate as his parents.

“Had my mother been certain her father was dead by 1945, I would have been named Nahum Zvi. Sixteen years later, in Jewish tradition, my nephew was given his name.”

Derman’s deep familiarity with unruly reality explains his disdain for financial models as all-knowing Gods. It also says a lot to me about why he’d rather teach than continue playing “master of the universe” at Goldman Sachs.

“You can count yourself lucky,” he says, “if your model of yourself survives its collision with time.”

We found out over dinner that we both enjoy Larkin, Nabokov, Joseph Cornell boxes, and Bellow.

Model that…

Professor Derman has invited me to speak February 6, 2012 at the Financial Engineering Practitioners Seminar at Columbia University. The seminar meets on Monday evenings from 6:00 p.m. to 7:30 p.m., and is followed by a reception and refreshments. The seminars are open to the public.

Tentative topic: Financial Engineering of a Different Sort – Using Models to Commit Fraud