A quant's view of models

Q: You're a creator of models, but you also work with real live traders. How far do models go? Where does their value stop? When can you put too much trust in them?

Emanuel Derman: I've been forced to be fairly pragmatic about them. There was a trading desk head who said that giving somebody a Black-Scholes calculator doesn't make him a trader. The models give you some way of thinking about the problem you're tackling, but they don't necessarily give you the answer.

I like to think of models as a Gedankenexperiments-the imaginary experiments physicists used to try to think about something they couldn't do, like sitting on the edge of a light beam and travelling at the speed of light.

I think that's what models are good for in finance. In most cases the world doesn't really behave in exactly the way as the model you've constructed. You're trying to make a poor approximation of reality, though it has big advantages. You can ask, "What happens if volatility goes up or interest rates go down?" It allows you to stress-test your view of the world in some way and then come up with a price based on what you can understand.

No paradox here, just to make the distinction between the accuracy and usefulness of models.