The Money Formula

CHAPTER 7The Rewrite

“The truth is, the Science of Nature has been already too long made only a work of the Brain and the Fancy: It is now high time that it should return to the plainness and soundness of Observations on material and obvious things.”

—Robert Hooke, Micrographia (1665)

“During emission testing, the vehicles' ECM ran software which produced compliant emission results under an ECM calibration that VW referred to as the ‘dyno calibration’… at all other times during normal vehicle operation, the ‘switch’ was activated and the vehicle ECM software ran a separate ‘road calibration’ which reduces the effectiveness of the emission control system.”

—The US Environmental Protection Agency explains how Volkswagen calibrated the electronic control module (ECM) in its diesel cars to pass emission tests.

Quants put values on esoteric financial products by using sophisticated mathematical models to simulate their behavior. Once a suitable model has been selected, it is first calibrated or tuned to existing data. This typically involves modifying various settings within the model, a process which is rather like adjusting the control surfaces of a model airplane, or tweaking the storyline of a screenplay after a screening. The model is then ready for launch. The quant can let it go and stand back to admire its performance. But what if, instead of working as expected, it veers off course and crashes? This chapter looks at the process of calibration, and shows that model tuning ...