Read MoreEssentially, all models are wrong, but some are useful.
- George Box
Read More"I don't think necessity is the mother of invention. Invention, in my opinion, arises directly from idleness, possibly also from laziness - to save oneself trouble."
- Agatha Christie
“I have two ways of learning from history: from the past, by reading the elders; and from the future, thanks to my Monte Carlo toy.”
- Nassim Taleb, Fooled by Randomness
In Part 1 (a suggested read if you’re getting to this article first) we proposed 3 questions that determine whether bond option pricing models, in contrast to real-world option models, are appropriate for tax-exempt issuers analyzing their callable bonds:
We see a lot of confusion in public finance as to how to analyze refundings. Unfortunately I think much of it stems from people outside of public finance coming in without a complete understanding of the environment in which a tax-exempt issuer operates i.e. the muni market. These interlopers get excited when they see option specifications in an official statement, then cry out, “We’ve seen these before. We have fantastic models used everywhere else, they must apply here too!” Unfortunately the foundational assumptions underpinning these models do not exist in the muni market leading this statement to be bunk (technical term my father used to use…). In fact those elegant bond options models do not apply in the muni flea market.
It’s 2015. Watson vanquished humans in Jeopardy 4 years ago and is now rapidly moving towards replacing as many oncologists as possible. Google is just one company running driverless cars and trucks around everywhere. Facebook is trying to monetize every eye twitch you make looking at a web page. Let’s check in on innovation in public finance:
"To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules." - The Financial Modeler's Manifesto, Emanual Derman and Paul Wilmott
"If people do not believe that mathematics is simple, it is only because they do not realize how complicated life is." - John von Neumann
I finally know what distinguishes man from the other beasts: financial worries.
- Jules Renard