In earlier chapters of Wilmott’s book, we modeled interest rates by picking one short-term rate and deriving the entire yield curve from it. Works fine for simple stuff. But Heath, Jarrow, and Morton said: why model just the short end when you can model the whole forward rate curve at once?
Wandering around the average investor’s mind is like taking a tour of Wonderland with the White Rabbit. Most of what we think is true is actually false.
Economics has a favorite character. The Rational Man. He always knows what he wants. He always picks the best option. He never panics, never gets confused, never makes a dumb choice because he’s tired or emotional.
If you think venture capital is a modern invention from Silicon Valley, think again. It’s actually hundreds of years old. In fact, Cyril Demaria argues that Christopher Columbus was one of the first great venture capitalists.
We have spent several chapters building interest rate models. Vasicek, CIR, Hull and White, Ho and Lee, Black-Derman-Toy. Each one chosen for its nice mathematical properties, clean closed-form solutions, and easy calibration. But here is the uncomfortable question Wilmott asks in Chapter 36: do any of these models actually match what interest rates do in the real world?
I’ve spent over 20 years in IT and a lot of time looking at charts and numbers. One thing I’ve learned is that the math is often the easy part. The hard part is the gray matter between your ears.
You ever watch financial news and hear someone say “the market broke through resistance” or “the market looks tired”? These phrases sound like the market is some living creature with feelings. And if you come from a science background, your first reaction is probably: what does that even mean?
Because it’s so hard to get good data on private equity, people start taking shortcuts. And those shortcuts lead to some big mistakes.
One-factor interest rate models have a fundamental problem. They assume that a single number, the spot interest rate, drives the entire yield curve. That means all rates of all maturities move together in lockstep. If the spot rate goes up by 1%, every other rate adjusts accordingly. The yield curve can shift up and down, but it cannot twist or tilt independently at different maturities.
Remember the dot-com bubble? Companies with zero profit, sometimes zero revenue, trading at insane valuations. Analysts invented new ways to justify the prices. “Forget earnings, count the eyeballs!” And for a while, it worked.