The Importance of Being Honest

This is a great article by E. Derman and Paul Wilmott on  how we should be careful with our models. Here are their suggestions at the end,

• I will remember that I didn't make the world and that 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. 

It is so easy to get lost in the mathematics of models that we often see papers completely out of touch with reality...

Man vs. Machine

Since the "flash crash" in May, there has been lots of talk about how computer trading algorithms  (i.e. algo trading) can crash the market by overwhelming the market with sell orders triggered after some event-based signal takes place.

Using computers to trade in the milisecond frequency makes it almost impossible for human beings to beat machines because there is no way to match their trading speed.

The FT last week had a very interesting story on how two (independent) Norwegian traders exploited a flaw in the algorithm of a U.S. firm to make money out of illiquid Norwegian stocks. So far so good, but the traders have been handed suspended prison sentences for market manipulation and a fine equal to their trading profits.

I find these charges a little odd. How come a computer that has a built in set of rules is not "manipulating" the markets when it places their orders? Two investors, doing a careful research job, find a flaw in the strategy and placed their bets, taking up the risk along with it. What's wrong with that? T

he U.S. firm is to blame for having a poor algorithm in the first place.Unfortunately this reminds me of that story saying that financial firms enjoy the profits but ask someone to bail them out in case of losses.