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EMANUEL DERMAN is Head of Risk at Prisma Capital Partners and a professor at Columbia University, where he directs their program in financial engineering. He is the author of My Life[…]

Emanuel Derman: In some sense, all of finance is about imagination because finance is about saying, what should something be worth today based on what I think is going to happen in the future?  Nobody knows what’s going to happen in the future.  And so all financial models are specifying in some way an imagined future and then saying, if that future is true, what should I pay for something today?

And so for example, if you’re building an option model, you’re saying, what will volatility be in the future?  And given my estimate of volatility in the future, I can value an option today. If you’re looking at CDO’s, which sort of came in a cropper in the big financial crisis, essentially human beings are saying, what will housing prices do in the future?  What will defaults on loans be and defaults on mortgages be?  And given my imagined scenario for the future, what should
I pay for something today that’s sensitive to that future behavior?  

The big failures, I think, are failures of imagination, not of mathematics.  The big mistakes are when you don’t’ think of something that does come to fruition eventually.

When I was in graduate school, I went to see a movie the night before my qualifying exams called, “Bedazzled” with Peter Cook and Dudley Moore. It’s about 40 years old, but I think it was remade a few years ago.  Dudley Moore - I think they’re both dead now, Dudley Moore and Peter Cook - he was a short-order cook at a Wimpy’s in London and he’s in love with the waitress that serves him.  Peter Cook plays the devil and offers him seven chances to seduce the waitress in exchange for his soul.  And so he agrees. And then he tries to specify the circumstances under which he will be with the waitress.  And so the first time, he says something like, he’d like to be in a fancy castle in Oxfordshire and with her and both of them in love with each other and both of them wealthy.  And the devil snaps his fingers, and there they are in this castle and they’re around the billiard table and they’re in love with each other, but she’s married to the owner of the castle and he’s just a guest.  And she has scruples, so she’s not willing to get involved with him.

And in every scenario he tries of these seven scenarios he gets it wrong.  In the last one he asks if they can both just be somewhere quiet with nobody to interfere with them and nobody talking, and they make them both nuns in a sort of Trappist monastery.

And so his imagination can never specify precisely enough the future that he’d like to have. And I think that’s sort of what goes wrong with a lot of financial models. You can’t really write down one short description of all the things that markets may do in the future.
Directed / Produced byJonathan Fowler & Elizabeth Rodd