I came across this nice article on Investopedia by Marv Dumon. So sharing it with you here.
Many, if not most, professionals have tied their sense of worth and self image to their position, responsibilities, title and compensation level. Salary is often viewed as the value that an efficient marketplace assigns to one's work, and a high wage structure associated with an individual can exponentially inflate an ego. At least, that seems to be the tendency in the Information Age and in this era of globalization.
Back in the Industrial Age and during times when agriculture and farming were the usual way to earn a living, workers were often content to secure a decent wage or harvest in order to provide food on the table for one's family. In times absent of welfare or social safety net programs, there was a sense of worth in being able to provide for those you cared about. To be sure, a tradition of gratefulness evolved in the laborer's ability to secure a sufficient livelihood.
Opposing Views
Today, recruiting firms and human resources managers entice candidates to join their respective finance organizations. Investment banking has long held a high regard in Wall Street and in corporate finance, which recruiters impress upon applicants. The role's prestige, heavy duty hours and responsibilities, accord opportunities to pursue an MBA at outstanding business schools, or to pursue other career opportunities in private equity, hedge fund industry or the Fortune 500. There is no denying that there is a chance to further elevate and enhance one's career down the road. Entry-level investment banking analysts have set high goals for themselves throughout their academic careers and undoubtedly continue to set their sights on aspirations as future managing directors, CFOs and CEOs.
There is an opposite view toward minimum wage laborers - workers who man fast food restaurants, janitors, personal assistants, law firm runners, gasoline station clerks and a whole variety of similar hourly labor.
But from a purely financial standpoint, which type of worker is really earning more? Let's make a simple comparison between John, an investment banker, and Bobby, an hourly worker at a fast food restaurant.
"John the Banker" Vs. "Bobby Burger Flipper"
Bobby Burger Flipper
Bobby Burger Flipper, who started at minimum wage of $7.25 per hour, has done a consistently good job at his fast food restaurant over the course of two years. Because he occasionally stays for night shifts, Bobby has been promoted to assistant store manager which raises his earnings to $11 an hour. Bobby received his GED high school diploma and has negligible debt mainly from personal expenses. Due to rising prices on a variety of consumables such as gasoline, and economic uncertainty, Bobby Burger Flipper has taken a second job, increasing the number of hours worked to 50 hours per week at the same hourly rate.
John the Banker
John the Banker is a freshly minted undergraduate degree holder. Because he went to an Ivy League institution, he has graduated with $100,000 in debt. John joins a famous Wall Street investment bank and is assigned on a deal team that does large cap deals. As a first-year investment banking analyst, he makes $55,000 a year at the firm's Miami office and is soon putting in about 100 hours per week.
Earning $55,000 a year, at 100 hours per week, and in the unfortunate scenario of zero bonus, John's hourly salary equates to $11. Additionally, John's student loan payments amount to over $300 a month. Bobby Burger Flipper, on the other hand, earns the same $11 an hour rate as John. While John enjoys the perception of being more successful than Bobby, he is actually earning less overall. (For more on working in finance, read Get Hired In Finance, Despite The Recession.)
The Compensation Myth
The value of John's education, and the debt he incurred in order to receive it, will no doubt come into play as John's career advances beyond entry-level. Bobby, on the other hand, may not have as far up to go. Then again, Bobby may advance to management of more than just his store and John may remain at a low-level job. The point is, the difference between them is nowhere near as much as is perceived.
The Bottom Line
Professionals and laborers have work preferences that come in all types and shapes. A CPA may be content quietly working 50-hour weeks at a Fortune 100 making $40 an hour. A newly-minted law school graduate may take an offer at a prestigious downtown law firm for $80,000 a year. The CPA's job may not seem "high powered" to the recent graduate, but given that first-year graduates can work 75-hour weeks, the hourly rate translates to a little over $21 an hour for a 50-week year. That's less than what many car mechanics, plumbers, electricians and jail guards make.
Friday, September 11, 2009
Thursday, May 14, 2009
Financial Terms-II
1) Financial Stability Plan (FSP)
It is a plan unveiled by the Obama administration in April 2009, and designed to stabilize the U.S. economy during the recent financial crisis . The Financial Stability Plan (FSP) promised to take measures to solidify the American banking system, securities markets, mortgage and consumer credit markets. This plan came as a response to the 2008 fallout in the mortgage and financial markets.
The FSP is estimated to cost the American taxpayer about USD1.0 Trillion. The FSP promised to create a new "public-private" governmental fund to absorb toxic assets and leverage private capital to stimulate the financial markets. It also aimed to standardize the banking system and provide capital to unstable lending institutions. A consumer-business lending initiative was also included to restore consumer credit for stable borrowers.
2) Bailout
It refers to a situation in which an individual, business, or government offers money to a failing business in order to prevent the consequences that arise from a business's downfall. Bailouts can take the form of loans, bonds, stocks or cash. They may or may not require reimbursement.
Bailouts have traditionally occurred in industries or businesses that may be perceived as no longer being viable, or are just sustaining huge losses. These companies typically employ a large number of people, leading some people to believe that the economy would be unable to sustain such a huge jump in unemployment if the business folded.
For example, Chrysler, a large U.S. automaker was in need of a bailout in the early 1980s. The U.S. government stepped in and offered roughly USD1.2 Billion to the failing company. Chrysler was able to repay the entire bailout , and is currently a profitable firm.
One of the biggest bailouts is the one proposed by the U.S. government in 2008 that will see USD700.0 Billion put toward bailing out various financial organizations and those affected by the credit crisis.
3) Troubled Asset Relief Program - TARP
It refers to a a government program created for establishing and managing a Treasury fund, in an attempt to curb the ongoing financial crisis.
TARP gives the U.S. Treasury purchasing power of USD700.0 Billion to buy mortgage backed securities (MBS) from institutions across the country, in an attempt to create liquidity and un-seize the money markets. The fund was created by a bill that was made law on October 3, 2008 with the passage of H.R. 1424 enacting the Emergency Economic Stabilization Act of 2008. The Treasury will be given USD250.0 Billion immediately, and the President must certify additional funds as they are needed. The additional funds will be distributed as USD100.0 Billion, and as the final USD350.0 Billion is given, Congress has the right to not approve the additional amounts.
Need for TARP
The global credit markets came to a near stand still in September 2008, as major financial institutions, such as Lehman Brothers, Fannie Mae, Freddie Mac and American International Group (AIG), went under. In a few surprising moves, heavyweights Goldman Sachs and Morgan Stanley even changed their charter to become commercial banks, in an attempt to stabilize their capital situation. The bailout will attempt to increase the liquidity of the secondary mortgage markets by purchasing the illiquid MBS, and through that, enable reduction in the potential losses that could be felt by the institutions who currently own them.
In October 2008, revisions to the program were announced by Treasury Secretary Paulson and President Bush; allowing for the first USD250.0 Billion to be used to buy equity stakes in nine major U.S. banks, and many smaller banks. This program demands that companies involved lose some tax benefits, and in many cases incur limits on executive compensation.
Source: Investopedia
It is a plan unveiled by the Obama administration in April 2009, and designed to stabilize the U.S. economy during the recent financial crisis . The Financial Stability Plan (FSP) promised to take measures to solidify the American banking system, securities markets, mortgage and consumer credit markets. This plan came as a response to the 2008 fallout in the mortgage and financial markets.
The FSP is estimated to cost the American taxpayer about USD1.0 Trillion. The FSP promised to create a new "public-private" governmental fund to absorb toxic assets and leverage private capital to stimulate the financial markets. It also aimed to standardize the banking system and provide capital to unstable lending institutions. A consumer-business lending initiative was also included to restore consumer credit for stable borrowers.
2) Bailout
It refers to a situation in which an individual, business, or government offers money to a failing business in order to prevent the consequences that arise from a business's downfall. Bailouts can take the form of loans, bonds, stocks or cash. They may or may not require reimbursement.
Bailouts have traditionally occurred in industries or businesses that may be perceived as no longer being viable, or are just sustaining huge losses. These companies typically employ a large number of people, leading some people to believe that the economy would be unable to sustain such a huge jump in unemployment if the business folded.
For example, Chrysler, a large U.S. automaker was in need of a bailout in the early 1980s. The U.S. government stepped in and offered roughly USD1.2 Billion to the failing company. Chrysler was able to repay the entire bailout , and is currently a profitable firm.
One of the biggest bailouts is the one proposed by the U.S. government in 2008 that will see USD700.0 Billion put toward bailing out various financial organizations and those affected by the credit crisis.
3) Troubled Asset Relief Program - TARP
It refers to a a government program created for establishing and managing a Treasury fund, in an attempt to curb the ongoing financial crisis.
TARP gives the U.S. Treasury purchasing power of USD700.0 Billion to buy mortgage backed securities (MBS) from institutions across the country, in an attempt to create liquidity and un-seize the money markets. The fund was created by a bill that was made law on October 3, 2008 with the passage of H.R. 1424 enacting the Emergency Economic Stabilization Act of 2008. The Treasury will be given USD250.0 Billion immediately, and the President must certify additional funds as they are needed. The additional funds will be distributed as USD100.0 Billion, and as the final USD350.0 Billion is given, Congress has the right to not approve the additional amounts.
Need for TARP
The global credit markets came to a near stand still in September 2008, as major financial institutions, such as Lehman Brothers, Fannie Mae, Freddie Mac and American International Group (AIG), went under. In a few surprising moves, heavyweights Goldman Sachs and Morgan Stanley even changed their charter to become commercial banks, in an attempt to stabilize their capital situation. The bailout will attempt to increase the liquidity of the secondary mortgage markets by purchasing the illiquid MBS, and through that, enable reduction in the potential losses that could be felt by the institutions who currently own them.
In October 2008, revisions to the program were announced by Treasury Secretary Paulson and President Bush; allowing for the first USD250.0 Billion to be used to buy equity stakes in nine major U.S. banks, and many smaller banks. This program demands that companies involved lose some tax benefits, and in many cases incur limits on executive compensation.
Source: Investopedia
Tuesday, May 5, 2009
Financial Terms-I
1) L,V and U
These alphabets refer to the types of recessions(i.e. L-shaped, V-shaped and U-shaped ones) according to economists globally.
*The L-shape recession is one that goes down and then stays there for a long period of time without a recovery. It could last for 20 years like it happened in Japan.
*A V-shape recession goes down pretty fast and recovers in very less time.
*A U-shape recession goes down slowly and then stays there for a few years before recovering slowly. It's length could be anywhere from 2-10 years, like in the 1970s in US where it lasted for 8 years.
Most of the times, it is the economic policy adopted by a government before recession, which determines what type of recession it is. Wrongly calibrated economic policies lead to L-shape recessions, which the worst of the lot.
2) Stress Testing
It refers to a simulation technique used on asset and liability portfolios to determine their reactions to different financial situations. Stress tests are also used to gauge the effects of certain stressors on a company or industry. They are usually computer-generated simulation models that test hypothetical scenarios.
It is a useful method for determining how a portfolio will fare during a period of financial crisis. One of the most widely used methods of stress testing, is the Monte Carlo simulation.
The strength of financial institutions can be also evaluated using a stress test.
An example would be, the Treasury Department running stress tests on banks to determine their financial condition. Banks often run these tests on themselves. Interest rates, lending requirements or unemployment could be among the changing factors.
3) Plain Vanilla
Refers to the standard or basic version of a financial instrument, usually options, bonds, futures and swaps. Plain vanilla is the opposite of an exotic instrument, which alters the components of a traditional financial instrument, which results in a more complex security.
E.g. a plain vanilla option would be the standard type of option, one with a simple expiration date and strike price and no additional features.
Source: News articles, Websites, Investopedia
These alphabets refer to the types of recessions(i.e. L-shaped, V-shaped and U-shaped ones) according to economists globally.
*The L-shape recession is one that goes down and then stays there for a long period of time without a recovery. It could last for 20 years like it happened in Japan.
*A V-shape recession goes down pretty fast and recovers in very less time.
*A U-shape recession goes down slowly and then stays there for a few years before recovering slowly. It's length could be anywhere from 2-10 years, like in the 1970s in US where it lasted for 8 years.
Most of the times, it is the economic policy adopted by a government before recession, which determines what type of recession it is. Wrongly calibrated economic policies lead to L-shape recessions, which the worst of the lot.
2) Stress Testing
It refers to a simulation technique used on asset and liability portfolios to determine their reactions to different financial situations. Stress tests are also used to gauge the effects of certain stressors on a company or industry. They are usually computer-generated simulation models that test hypothetical scenarios.
It is a useful method for determining how a portfolio will fare during a period of financial crisis. One of the most widely used methods of stress testing, is the Monte Carlo simulation.
The strength of financial institutions can be also evaluated using a stress test.
An example would be, the Treasury Department running stress tests on banks to determine their financial condition. Banks often run these tests on themselves. Interest rates, lending requirements or unemployment could be among the changing factors.
3) Plain Vanilla
Refers to the standard or basic version of a financial instrument, usually options, bonds, futures and swaps. Plain vanilla is the opposite of an exotic instrument, which alters the components of a traditional financial instrument, which results in a more complex security.
E.g. a plain vanilla option would be the standard type of option, one with a simple expiration date and strike price and no additional features.
Source: News articles, Websites, Investopedia
Thursday, April 30, 2009
Private Equity Round Up - January 2009
Global Private Equity (PE) Activity
The premier month of 2009 saw a drastic slowdown in global PE activity.
The USD33.0 Billion mark was crossed by fresh fund closures.This included 3i’s USD13.7 Billion investment and CVC’s funding of EUR11.0 Billion.
In percentage terms, North America accounted for highest number of closures 56%, while Europe and Asia accounted for 37% and5% respectively.
US received the maximum investment, to the tune of nearly USD15.0 Billion, followed by Asia Pacific with about USD482.0 Million.
The sector with the most number of investments was Computers & Internet, followed by the Industrial/Energy sector.
The largest deal, amountiong to USD 13.9 Billion was the buyout of Indymac by J.C. Flowers & Co. LLC, MSD Capital L.P., and some undiclosed firms.
Indian PE Activity
In India, The PE investment dropped sharply to less than USD100.0 Million with a dozen deals in January 2009,a far cry from the USD3.0 Billion investment with over 60 deals in January 2008. The Engineering & Construction sector had the highest PEinvestment amounting to USD36.0 Million.
Two notable deals were
* The acquisition of a 17.7% stake in Hyderabad-based infrastructure company Coastal Projects for USD36.4 Million by Citigroup Venture Capital International (CVCI).
* Three Indian companies recevived investment to the tune of USD23.0 Million from
Intel Capital, the investment arm of Intel Corp. IndiaMART.com, an online business-to-business marketplace, received an investment of USD10.0 Million while the remaining USD13.0 Million was allocated to Global Talent Track, a vocational educational institute, and One97 Communications Pvt. Ltd., a provider of value-added services such as ring tones and games for mobile phones.
Source: PE News Reports and Articles
Wednesday, March 18, 2009
The Financial Modeler's Manifesto
I came across this wonderfully written, thought-provoking manifesto written by reputed quantitative finance gurus, Emanuel Derman and Paul Wilmott.
The Financial Modelers' Manifesto
Preface
A spectre is haunting Markets – the spectre of illiquidity, frozen credit, and the failure of financial models.
Beginning with the 2007 collapse in sub prime mortgages, financial markets have shifted to new regimes characterized by violent movements, epidemics of contagion from market to market, and almost unimaginable anomalies (who would have ever thought that swap spreads to Treasuries could go negative?).
Familiar valuation models have become increasingly unreliable. Where is the risk manager that has not ascribed his losses to a once in- a-century tsunami?
To this end, we have assembled in New York City and written the following manifesto.
Manifesto In finance we study how to manage funds – from simple securities like dollars and yen, stocks and bonds to complex ones like futures and options, sub prime CDOs and credit default swaps. We build financial models to estimate the fair value of securities, to estimate their risks and to show how those risks can be controlled. How can a model tell you the value of a security? And how did these models fail so badly in the case of the sub prime CDO
market? Physics, because of its astonishing success at predicting the future behavior of material objects from their present state, has inspired most financial modeling. Physicists study the world by repeating the same experiments over and over again to discover forces and their almost magical mathematical laws. Galileo dropped balls off the leaning tower, giant teams in Geneva collide protons on protons, over and over again. If a law is proposed and its predictions contradict experiments, it's back to the drawing board. The method works. The laws of atomic physics are accurate to more than ten decimal places.
It's a different story with finance and economics, which are concerned with the mental world of monetary value. Financial theory has tried hard to emulate the style and elegance of physics in order to discover its own laws. But markets are made of people, who are influenced by events, by their ephemeral feelings about events and by their expectations of other people's feelings. The truth is that there are no fundamental laws in finance. And even if there were, there is no way to run repeatable experiments to verify them. You can hardly find a better example of confusedly elegant modeling than models of CDOs. The CDO research papers apply abstract probability theory to the price co-movements of thousands of mortgages. The relationships
between so many mortgages can be vastly complex. The modelers, having built up their fantastical theory, need to make it usable; they resort to sweeping under the model's rug all unknown dynamics; with the dirt ignored, all that's left is a single number, called the default correlation. From the sublime to the elegantly ridiculous: all uncertainty is reduced to a single parameter that, when entered into the model by a trader, produces a CDO value.
This over-reliance on probability and statistics is a severe limitation. Statistics is shallow description, quite unlike the deeper cause and effect of physics, and can’t easily capture the complex dynamics of default. Models are at bottom tools for approximate thinking; they serve to transform your intuition about the future into a price for a security today. It’s easier to think intuitively about future housing prices, default rates and default correlations than it is about CDO prices. CDO models turn your guess about future housing prices, mortgage default rates and a simplistic default correlation into the model’s output: a current CDO price.
Our experience in the financial arena has taught us to be very humble in applying mathematics to markets, and to be extremely wary of ambitious theories, which are in the end trying to model human behavior. We like simplicity, but we like to remember that it is our models that are simple, not the world.
Unfortunately, the teachers of finance haven’t learned these lessons. You have only to glance at business school textbooks on finance to discover stilts of mathematical axioms supporting a house of numbered theorems, lemmas and results. Who would think that the textbook is at bottom dealing with people and money? It should be obvious to anyone with common sense that every financial axiom is wrong, and that finance can never in its wildest dreams be Euclid. Different endeavors, as Aristotle wrote, require different degrees of precision. Finance is not
one of the natural sciences, and its invisible worm is its dark secret love of mathematical elegance and too much exactitude.
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.
Many academics imagine that one beautiful day we will find the ‘right’ model. But there is no right model, because the world changes in response to the ones we use. Progress in financial modeling is fleeting and temporary. Markets change and newer models become necessary. Simple clear models with explicit assumptions about small numbers of variables are therefore the best way to leverage your intuition without deluding yourself.
All models sweep dirt under the rug. A good model makes the absence of the dirt visible. In this regard, we believe that the Black-Scholes model of options valuation, now often unjustly maligned, is a model for models; it is clear and robust. Clear, because it is based on true engineering; it tells you how to manufacture an option out of stocks and bonds and what that will cost you, under ideal dirt-free circumstances that it defines. Its method of valuation is analogous to figuring out the price of a can of fruit salad from the cost of fruit, sugar, labor and
transportation. The world of markets doesn’t exactly match the ideal circumstances Black-Scholes requires, but the model is robust because it allows an intelligent trader to qualitatively adjust for those mismatches. You know what you are assuming when you use the model, and you know exactly what has been swept out of view.
Building financial models is challenging and worthwhile: you need to combine the qualitative and the quantitative, imagination and observation, art and science, all in the service of finding approximate patterns in the behavior of markets and securities. The greatest danger is the age-old sin of idolatry. Financial markets are alive but a model, however beautiful, is an artifice. No matter how hard you try, you will not be able to breathe life into it. To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules.
MODELERS OF ALL MARKETS, UNITE! You have nothing to lose but your illusions.
The Modelers' Hippocratic Oath
~ I will remember that I didn't make the world, and it doesn't satisfy my equations.
~ Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
~ I will never sacrifice reality for elegance without explaining why I have done so.
~ Nor will I give the people who use my model false comfort about its accuracy.
Instead, I will make explicit its assumptions and oversights.
~ I understand that my work may have enormous effects on society and the economy,
many of them beyond my comprehension
Source: http://www.wilmott.com/blogs/eman/index.cfm/2009/1/8/The-Financial-Modelers-Manifesto
The Financial Modelers' Manifesto
Preface
A spectre is haunting Markets – the spectre of illiquidity, frozen credit, and the failure of financial models.
Beginning with the 2007 collapse in sub prime mortgages, financial markets have shifted to new regimes characterized by violent movements, epidemics of contagion from market to market, and almost unimaginable anomalies (who would have ever thought that swap spreads to Treasuries could go negative?).
Familiar valuation models have become increasingly unreliable. Where is the risk manager that has not ascribed his losses to a once in- a-century tsunami?
To this end, we have assembled in New York City and written the following manifesto.
Manifesto In finance we study how to manage funds – from simple securities like dollars and yen, stocks and bonds to complex ones like futures and options, sub prime CDOs and credit default swaps. We build financial models to estimate the fair value of securities, to estimate their risks and to show how those risks can be controlled. How can a model tell you the value of a security? And how did these models fail so badly in the case of the sub prime CDO
market? Physics, because of its astonishing success at predicting the future behavior of material objects from their present state, has inspired most financial modeling. Physicists study the world by repeating the same experiments over and over again to discover forces and their almost magical mathematical laws. Galileo dropped balls off the leaning tower, giant teams in Geneva collide protons on protons, over and over again. If a law is proposed and its predictions contradict experiments, it's back to the drawing board. The method works. The laws of atomic physics are accurate to more than ten decimal places.
It's a different story with finance and economics, which are concerned with the mental world of monetary value. Financial theory has tried hard to emulate the style and elegance of physics in order to discover its own laws. But markets are made of people, who are influenced by events, by their ephemeral feelings about events and by their expectations of other people's feelings. The truth is that there are no fundamental laws in finance. And even if there were, there is no way to run repeatable experiments to verify them. You can hardly find a better example of confusedly elegant modeling than models of CDOs. The CDO research papers apply abstract probability theory to the price co-movements of thousands of mortgages. The relationships
between so many mortgages can be vastly complex. The modelers, having built up their fantastical theory, need to make it usable; they resort to sweeping under the model's rug all unknown dynamics; with the dirt ignored, all that's left is a single number, called the default correlation. From the sublime to the elegantly ridiculous: all uncertainty is reduced to a single parameter that, when entered into the model by a trader, produces a CDO value.
This over-reliance on probability and statistics is a severe limitation. Statistics is shallow description, quite unlike the deeper cause and effect of physics, and can’t easily capture the complex dynamics of default. Models are at bottom tools for approximate thinking; they serve to transform your intuition about the future into a price for a security today. It’s easier to think intuitively about future housing prices, default rates and default correlations than it is about CDO prices. CDO models turn your guess about future housing prices, mortgage default rates and a simplistic default correlation into the model’s output: a current CDO price.
Our experience in the financial arena has taught us to be very humble in applying mathematics to markets, and to be extremely wary of ambitious theories, which are in the end trying to model human behavior. We like simplicity, but we like to remember that it is our models that are simple, not the world.
Unfortunately, the teachers of finance haven’t learned these lessons. You have only to glance at business school textbooks on finance to discover stilts of mathematical axioms supporting a house of numbered theorems, lemmas and results. Who would think that the textbook is at bottom dealing with people and money? It should be obvious to anyone with common sense that every financial axiom is wrong, and that finance can never in its wildest dreams be Euclid. Different endeavors, as Aristotle wrote, require different degrees of precision. Finance is not
one of the natural sciences, and its invisible worm is its dark secret love of mathematical elegance and too much exactitude.
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.
Many academics imagine that one beautiful day we will find the ‘right’ model. But there is no right model, because the world changes in response to the ones we use. Progress in financial modeling is fleeting and temporary. Markets change and newer models become necessary. Simple clear models with explicit assumptions about small numbers of variables are therefore the best way to leverage your intuition without deluding yourself.
All models sweep dirt under the rug. A good model makes the absence of the dirt visible. In this regard, we believe that the Black-Scholes model of options valuation, now often unjustly maligned, is a model for models; it is clear and robust. Clear, because it is based on true engineering; it tells you how to manufacture an option out of stocks and bonds and what that will cost you, under ideal dirt-free circumstances that it defines. Its method of valuation is analogous to figuring out the price of a can of fruit salad from the cost of fruit, sugar, labor and
transportation. The world of markets doesn’t exactly match the ideal circumstances Black-Scholes requires, but the model is robust because it allows an intelligent trader to qualitatively adjust for those mismatches. You know what you are assuming when you use the model, and you know exactly what has been swept out of view.
Building financial models is challenging and worthwhile: you need to combine the qualitative and the quantitative, imagination and observation, art and science, all in the service of finding approximate patterns in the behavior of markets and securities. The greatest danger is the age-old sin of idolatry. Financial markets are alive but a model, however beautiful, is an artifice. No matter how hard you try, you will not be able to breathe life into it. To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules.
MODELERS OF ALL MARKETS, UNITE! You have nothing to lose but your illusions.
The Modelers' Hippocratic Oath
~ I will remember that I didn't make the world, and it doesn't satisfy my equations.
~ Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
~ I will never sacrifice reality for elegance without explaining why I have done so.
~ Nor will I give the people who use my model false comfort about its accuracy.
Instead, I will make explicit its assumptions and oversights.
~ I understand that my work may have enormous effects on society and the economy,
many of them beyond my comprehension
Source: http://www.wilmott.com/blogs/eman/index.cfm/2009/1/8/The-Financial-Modelers-Manifesto
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