Saturday, December 13, 2008

Physicists vs. economists

J. Doyne Farmer of the Sante Fe Institute, makes an interesting claim in Nature about the two cultures involved in quantitative finance, namely those of physicists and economists:

"Quantitative hedge funds tend to divide into those run by economists and those run by scientists from other disciplines, such as physics, maths or computer science...This distinction is not just a matter of professional pride and disciplinary boundaries...economists and physicists traditionally approach the problem of risk control in different ways. Risk control is the art of determining the likelihood of large and unexpected price changes happening in the future. It is well known that extremely large changes, and financial crashes in particular, are more frequent than would be expected from a 'normal' statistical distribution. Physicists tend to favour a 'power law' mathematical description to model the heavy tails of these distributions, giving a pessimistic view of the likelihood of large price movements. By contrast, the economists...spoke about price movements in terms of standard deviations, a terminology that is only relevant for normal distributions. This demonstrates that they were not thinking about the problem in the right way...Wall Street should follow the conservative approach to risk control that arises from properly modelling risks as power laws."

It's certainly true that econophysics recognized the existence of power law distributions, as this excellent paper by Dean Rickles exemplifies. I suspect, in addition, that there are also plenty of financial institutions in which physicists and mathematicians were responsible for developing the quantitative models, but in which economists and financial managers were responsible for the interpretation and application thereof. It is the latter group of individuals who would have largely been responsible for not incorporating the consequences of power law distributions into their value-at-risk calculations.

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