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The flawed maths of financial models (Financial Times)

By Pablo Triana -- Published: November 29 2010 00:00 | Last updated: November 29 2010 00:00

Imagine a car school that specialised in teaching how to build Toyotas. Following the manufacturer’s recall of thousands of malfunctioning vehicles, should the school rethink its curriculum or should it trot along unperturbed, delivering the same lectures as before, as if nothing had happened?

A similar conundrum is faced today by those universities that offer graduate programmes in what we could generally label quantitative finance. The credit crisis that started in mid-2007 has brought to the surface serious malfunctions in some glorified financial mathematical models as well as the tendency of finance theory’s most sacred tenets to calamitously break down. The models did not just fail, they contributed, decisively in my opinion, to the unleashing of the mayhem.

This comes on the heels of other monstrous quantitative disappointments, such as the stock market crash of October 1987 and the September 1998 failure of Long-Term Capital Management; in fact, it is reasonable to argue that the worst market crises since 1929 were all aided, abetted and directly caused by flawed analytical concoctions.
In all those cases, the system’s very viability was threatened. Improper maths came close to sinking us for good.

So, what should the many schools worldwide, including several leading business schools, hosting quant finance programmes do? Should they remain unperturbed and not change a thing or should they learn from the lessons of real life and adapt? Should they doubt themselves in the face of math-fuelled chaos?

Needless to say, the most intelligent and pro-social step would be to engage immediately in curricula reform. What many already strongly suspected has been proclaimed true by events: quantifying in finance may be an oxymoron.

Painful or not, profound change is needed and should be delivered. To act otherwise would be tantamount to declaring yourself impervious to
real-life developments. Schools should consider the following steps:

● Quant finance programmes must start focusing on why and how financial modelling can be useless and dangerous.


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