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Derman Rambles on Risk

Thu, 15 Mar 2012 20:48:37 GMT

I generally find Emmanuel Derman to be a very thoughtful, but this interview with Russ Roberts made little sense. They were talking about Derman's latest book Models Behaving Badly, and they had these little riffs on financial theory:

Derman: But I think Black-Scholes is much better than CAPM. Although it is based on the same idea. Because different stocks really have such different risk characteristics that the assumptions of geometric Brownian motion and the assumptions in CAPM don't hold very well for individual stocks.

I don't know what he means by the risk from geometric Brownian motion. I don't see how this assumption is essential to the arguments of the CAPM or Black-Scholes, which follow in a two-period model even more easily than using stochastic calculus.

Derman: I know Burton Malkiel reviewed my book in the Wall Street Journal, and he liked it generally, he was complimentary, but he claims in one paragraph that I was putting too much weight--he sort of claimed that all the efficient market model says is, I don't know what's going to happen next, as opposed to saying that current prices are right.
Russ: The first claim is a modest claim.
Derman: Yes, it is a modest claim. And I think maybe he is technically correct, but I think in everyday parlance people strive for a stronger version of it.
Russ: Yeah; I think the way you wrote it in the book is that prices reflect all publically available information.
Derman: Yes.

I think Derman is wrong here, and this is important. Malkiel was arguing against Derman's conflation of a post hoc wrong price (ie, one that recently moved a lot), with an efficient price. According to this conception of efficient markets, every time anything significant is not foreseen, markets are inefficient. Fine, but I don't know any researchers who think markets are that prescient, so it's a straw man argument that doesn't help the debate. You can say that's the common conception among your colleagues, but that just means your colleagues like beating up straw men arguments in this domain.

Interestingly, even Eugene Fama chirped in the comment section to say, 'great interview [throat clearing!], but he doesn't understand these points.'

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