Putting Economics (Back) into Quantitative Models

Models devoid of strong economic underpinnings are seldom useful for practical real-world investment decisions. Models that differ in subtle ways in their underlying assumptions yield significantly conflicting results. Ignoring the fundamental relation between demand and supply dynamics can produce results that fail to hold in actual markets, and that often give but false comfort in risk measurement systems and inaccurate valuations. A parsimonious model of the term structure can incorporate economics without sacrificing theoretical rigor. Its risk-neutral term structure model parameters have a strong basis in widely followed macroeconomic variables, enabling extension to other markets such as the credit market. TOPICS:Quantitative methods, statistical methods, legal/regulatory/public policy