Tuesday, 1 March 2011

Average or ultimate - which way to reality?

OK – here goes. I haven’t blogged for a couple of months – busy months (true) but more down to the fact that there has not been anything really interesting happening in the world of finance. My dozen PhD/DBA students battle their weary way to first draft and a lot of my time is spent reading, correcting, looking for the flaws, checking odd assertions, insisting that conclusions must be preceded by analysis and results and that sort of thing. One thing I have become certain of is that in finance and (I suspect) in many other disciplines we walk on shifting sand, Understanding is hard gained and even then it’s disputed.

However, not all depression on this first day of March – my reading about climate change has led me into some excellent literature on multiple methods- ensemble testing, triangulation and other techniques which are readily applicable to the world of finance. To follow this up I had an interesting discussion with an excellent doctoral student of mine who is developing option pricing models based upon Levy processes. After some deliberation we came to the view that diversity in modelling might be a more productive route to greater precision rather than seeking the Holy Grail of the ultimate model. I am no convinced that in finance there are no ultimate models. Markets are a consensus across a very large range of more or less deficient models. These are the models of reality which every trader has in their head when they come to evaluate the value of their investment. The ultimate model is that rather boring old average. Markets are huge averaging machines – we need to be no more nor no less sophisticated than that.

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