Econophysics - Economists, You Know Where the Door Is?

Michael Casey has written a provocative essay in Wall Street Journal. Let's face it, economists make lousy economists, he summarizes.

I am interested in the the theory of complex systems, complexity economy and especially its influence on quant finance. Here I have written about major achievements of econophysics.

In short, econophysics wants to solve problems in economics applying methods from physics. One driving force behind econophysics was the emergent availability of a huge amount of data. Basic tools are probabilistic and statistical methods often taken from statistical physicsMoreover, IMO, attempts to use the theory of complex systems.

In quantitative finance analogies between financial theory and diffusion theory are assumed (with all pros and cons). The stochastic differential equations are often transformed into partial differential equations and depending on deal types and contract features it is essential to have robust solvers and to treat the ill-posed inverse problem of calibration correctly. And they need to be blazingly fast to allow for comprehensive ... across scenario analytics.

However, derivatives and risk analytics is characterized by the influence of a few factors (dominantly volatility of underlyings, correlations, ...), high dimensions come from the path dependence.

To study, say, market behavior or understanding systemic risk insights from the physical world can help, especially from systems in which networks of interacting units produce radical collective behavior.

We have mentioned principle influences from the dynamic of "surrounding" systems, like on portfolio optimization here, or the non-ergodicity property (a property of Brownian Motion) here.

Things like co-movements of, say, financial instruments are important - it is, for example, quite intuitive that in a panic co-movement increases - a stock market panic is like an avalanche where exogenous control becomes less important compared to streamline interactions within the network.

The UnRisk team members are physicists, industrial mathematicians and computer scientists. We quite often see the limits of quant finance models by looking into the mathematics and data. And we motivate our customers to simulate more, look deeper into pathologic behavior, ...

Market behavior is complex. Complexity economy matters.