When people talk about how a new revolution in economics and finance is right around the corner, or already ongoing, I hear more of a wish than a promise. I heard it first when there was that article about how economics needs to ditch math that was beaten up by economists a few months ago, and I heard it in the Eichengreen piece. Finance is already incredibly statistical and empirical; one can’t even begin to approach the literature without a deep understanding of panel data and time series methods.
What I’d argue is that we need newer theory more than newer statistics. I’ll talk about the Efficient Market Hypothesis soon, but for now, how’s that theory looking from the quant side?
What’s a P/E ratio? Save that for the MBAs! There it is, a mean and a normal distributed volatility (the sigma in the second term). Glorious.
True story: Me and Ms. Rortybomb, an ethnomusicologist who, at last note, does not know the difference between a stock and a bond, were at a bookstore. On the math shelf was Applied Stochastic Control of Jump Diffusions. Bernt Øksendal is a superman – his book Stochastic Differential Equations is fantastic, a great high-end intro.
I pointed out to Ms. Rortybomb “this book may change the very idea of how we do quant work.” “Really? That would be great, given the financial crisis and all.” “I know. Check this bad boy out. This equation is how we used to do things [point to equation above]. In the future we may do it like this” and I point to these equations from the book:
“Haha. That’s funny. But seriously, where’s the new deal?”
Me, “why is that funny? That’s going to be intense. I fear the science is too tight for most quants, though those who can pull that off are going to be super-sweet.”
“No, but seriously, I thought everything was going to be different because of the crisis with finance and economics. I mean, isn’t it going to be less crazy math and equations and stuff?”
Me, “What do you mean not different? There are two additional integral signs we are talking about.”
“But isn’t there going to be more looking at the actual stuff and less leverage and betting and computers and stuff? I thought all this math was discredited.”
Me, “Discredited? Oh no, with those two additional integration signs I’m more comfortable taking on more leverage than ever before. Trust me, next time we are going to do it way better with these two additional integral signs.”
Her, getting sad, “Next time? Really? Next time – it’s not going to be any different?”
No. It’ll be the same, with just more math stuffed on top of the old math. Trust me, I’m going to integrate the hell out of your 401(k) with that second equation when I get the chance. If you are uncomfortable with that second equation as my whole approach, you may want to use this crisis as an opportunity to push for better regulation.