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Next Generation Quantitative Models for Risk Management Practices

In the wake of the recent Global Financial Crisis of 2008, world's top quantitative finance scholar-practitioners such as Dr. Emanuel Derman, prior head of the Quantitative Strategies at Goldman Sachs and currently professor at Columbia University, have underscored the need for advancing global Quantitative finance models so that they can effectively deal with the real '(Mis)behaviour of Markets', as noted Yale mathematician Dr. Benoit B. Mandelbrot would have said. In above context, Yogesh Malhotra's focus is on Quantitative Finance Models for development of next-generation risk management, asset valuation, risk arbitrage, and, trading and hedging strategies. Such strategies are critical for pre-empting and managing risks resulting from increasing recurrence of radical discontinuous changes, popularly known as 'extreme events' and 'black swans' in the aftermath of the Global Financial Crisis. For instance, his recent applied focus is on non-linear and non-normal stochastic volatility market events given systemic risks posed by $700 trillion dollars in derivatives markets alone.

'The Human Factor': What is Exactly Missing from Quantitative Models?

How our Research and Practices are contributing to Next Generation Risk Management

“The models, according to finance experts and economists, did fail to keep pace with the explosive growth in complex securities, the resulting intricate web of risk and the dimensions of the danger. But the larger failure, they say, was human — in how the risk models were applied, understood and managed... If the incentives and the systems change, the hard data can mean less than it did or something else than it did…The danger is that the modeling becomes too mechanical….The miss by Wall Street analysts shows how models can be precise out to several decimal places, and yet be totally off base… Indeed, the behavioral uncertainty added to the escalating complexity of financial markets help explain the failure in risk management. The quantitative models typically have their origins in academia and often the physical sciences. In academia, the focus is on problems that can be solved, proved and published — not messy, intractable challenges. In science, the models derive from particle flows in a liquid or a gas, which conform to the neat, crisp laws of physics. Not so in financial modeling. To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules.”

--- 'In Modeling Risk, the Human Factor Was Left Out' - The New York Times, November 5, 2008

Risk management in quantitative finance and applied finance is primarily about information and how people use information for decision-making regarding risks and returns. Finance experts such as Emanuel Derman and Paul Wilmott have been quite vocal about how related key assumptions underlying last generation quantitative finance models are questionable. In contrast to those models, our risk management research and practices are firmly grounded in cutting-edge fundamental research and applied understanding of information, systems, and how people use information for decision-making. Our fundamental research and applied practices on these matters are known for guiding worldwide corporations, governments, and institutions.

“I began to believe it was possible to apply the methods of physics successfully to economics and finance, perhaps even to build a grand unified theory of securities….After twenty years on Wall Street I’m a disbeliever. The similarity of physics and finance lies more in their syntax than their semantics. In physics you’re playing against God, and He doesn’t change His laws very often. In finance you’re playing against God’s creatures, agents who value assets based on their ephemeral opinions.”

--- Dr. Emanuel Derman, Columbia University Professor, ex-Goldman Head of Quantitative Trading, and author of the book My Life as a Quant in his new book Models Behaving Badly: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life, 2011.

“The complex financial models that got us into this mess too often mask human nature behind false limitations of risk ...Financial theory has tried hard to emulate physics and discover its own elegant, universal laws. But finance and economics are concerned with the human world of monetary value. Markets are made of people who are influenced by events, by their feelings about events, and by their expectations of other people's feelings about events...Financial theories written in mathematical notation - aka models - imply a false sense of precision. Good modelers know that... Financial markets are alive. A model, however beautiful, is an artifice. To confuse the model with the world is to embrace a future disaster in the belief that humans obey mathematical principles.”

--- Dr. Emanuel Derman, and, Dr. Paul Wilmott in Financial Models Must Be Clean and Simple, Business Week, Bloomberg, December 31, 2008.

“Of course, assets are not really geometric Brownian motions with constant volatility…”“Of course, stock price movements are much more complicated than indicated by the binomial asset-pricing model…”“Of course the actual probability for the occurrence of any particular [stock price] path is zero…”

--  Dr. Steve E. Shreve and co-authors in Stochastic Calculus for Finance II: Continuous-Time Models, Springer, 2010; Stochastic Calculus for Finance I: The Binomial Asset Pricing Model, Springer, Jun 28, 2005; Brownian Motion and Stochastic Calculus, Springer, 1991.

“We are now in a position to introduce a very important principle in the pricing of derivatives known as risk-neutral valuation. This states that, when valuing a derivative, we can make the assumption that investors are risk-neutral. This assumption means investors do not increase the expected return they require from an investment to compensate for increased risk. A world where investors are risk-neutral is referred to as a risk-neutral world. The world we live in is, of course, not a risk-neutral world. The higher the risks investors take, the higher the expected returns they require.”

-- Dr. John C. Hull in Options, Futures, and Other Derivatives, Prentice-Hall, 2011.

Yogesh Malhotra's ongoing quest for next-generation Risk Management and Quantitative Finance models is based on culmination of applied practices and influential research focused upon information and how people use information for decision-making. This quest is focused on advancing Global Finance and Risk Management quantitative modeling practices beyond archaic notion of prediction of an inherently indeterminate discontinuous future based on outdated data toward anticipation of surprise.

"I think you have hit upon an area that has seen very little coordinated research. There has been an over-concentration on Shannon's definition of information in terms of uncertainty (a very good definition for the original purposes) with little attempt to understand how MEANING directs a message in a network. This, combined with a concentration on end-points (equilibria) rather than proper- ties of the trajectory (move sequence) in games has lead to a very unsatisfactory treatment of the dynamics of organizations." - Dr. John H. Holland, 'The Father of Genetic Algorithms', personal communication, in Malhotra, Y. "Expert systems for knowledge management: [Managing uncertainty by] crossing the chasm between information processing and sense making," Expert Systems with Applications: An International Journal, 20, 2001.

"The future is moving so quickly that you can't anticipate it...We have put a tremendous emphasis on quick response instead of planning. We will continue to be surprised, but we won't be surprised that we are surprised...We will anticipate the surprise." - Dr. Steven Kerr, in Planning Review, quoted in Malhotra, Y. Knowledge Management and New Organization Forms: A Framework for Business Model Innovation, Knowledge Management and Business Model Innovation, 2001.

"In the increasing-returns world, especially in high tech, re-everything has become necessary because every time the quest changes the company needs to change. It needs to reinvent its purpose, its goals, its way of doing things." -- Dr. W. Brian Arthur in 'Increasing Returns and the New World of Business', Harvard Business Review, quoted in Malhotra, Y. "Integrating knowledge management technologies in organizational business processes: getting real time enterprises to deliver real business performance," Journal of Knowledge Management, Volume 9 Number 1, 2005.

Influential Research on Risk Management of Radical Discontinuities aka Black Swans

Systemic Risk Management of Extreme Events and Quantitative Models of Controls, Compliance, and, Regulation in WWW-based Networked Systems

Finance-IT-Risk Management Practitioner Yogesh Malhotra's doctoral and post-doctoral research developed original understanding of Knowledge Management as a discipline of systemic (system wide) risk management for business environments characterized by radical discontinuities: popularly known as extreme events and black swans after the global financial crisis. Recognizing fundamental limitations in the mainstream model of IT-based systems and controls for 'prediction' of future based upon 'historical' data, his published doctoral and post-doctoral research also developed original thinking on IT-based systems for 'anticipation of surprise.' The term 'anticipation of surprise' and published research on self-adaptive systems [such as the papers on next generation expert systems and self-adaptive systems for managing systemic risks] were inspired by works of scholars-practitioners such as Dr. Steven Kerr, CLO and Vice President of leadership development for G.E. [and subsequently CLO and Managing Director for Goldman Sachs], and, complexity theorists studying self-adaptive systems at the Santa Fe Institute such as father of genetic algorithms Dr. John H. Holland, Professor of Computer Science and Engineering and Professor of Psychology at the University of Michigan, and prior Stanford University Dean and Economist Dr. Brian Arthur.

Given expressed interest in the next generation self-adaptive complex systems such as digital virtual organizations and virtual networks, he was invited to pursue doctoral research fellowship at the University of Pittsburgh Katz Graduate School of Business by the University Professor Dr. William R. King (PhD, Operations Research), a 'renaissance scholar' among top-10 founders of the global Information Systems discipline renowned as the pioneer of IT Strategy. In course of the Ph.D. research fellowship, he published original research on Systemic Risk Management for environments characterized by Radical Discontinuities, popularized later as Extreme Events after the Global Financial Crisis of 2008. His published doctoral and post-doctoral research also developed original theoretical understanding about Self-Adaptive Complex Systems for 'Anticipation of Surprise' to address intrinsic limitations in 'Prediction' of Future based on 'Historical' and outdated Data, Logic, and Assumptions. A key focus of his basic empirical research on knowledge management was on the psychology and strategy of information processing, construction of meaning, and, decision making for an increasingly less predictable world. His Ph.D. thesis focused on empirical Statistical Quantitative Modeling of Risk Management (Controls & Compliance) in WWW-based Networked Enterprise Communication, Coordination, and Collaboration Systems. As primary investigator in course of the field study spanning three years, he worked as Management Consultant to CIO's office and seniormost MDs at the University of Pittsburgh Medical Center (UPMC) for pioneering implementation of enterprise-level WWW-based Networked Communication, Coordination, and Collaboration Systems and digitization of Electronic Medical Records in the U.S. Health Care Sector.

"Strategic discontinuities are like flash floods and tornadoes: they don't happen very often, but when they do, they can have devastating consequences... Strategic discontinuities must be anticipated; they can't be identified from trends alone because, unlike trends, they represent a break from what was done in the past, not a projection of the past into the future. Intuition and sharp peripheral vision are the key skills in anticipating strategic discontinuities." - Dr. Henry H. Beam, in Strategic Discontinuities: When Being Good May Not Be Enough, Business Horizons, July-August 1990.

"The highest endeavor of the mind, Spinoza concluded, and the highest virtue, is to understand things by the intuitive kind of knowledge. Intuition may sound casual and unfocused, but actually it takes intimate knowledge of the world that can be acquired only by careful observation and painstaking effort. When you struggle with a field of inquiry and a model for a long long time and you eventually master and incorporate not only its formalism but its content, you can make use of it to build things one level higher. Intuition is a merging of the understander with the understood." - Dr. Emanuel Derman, in On Fischer Black: Intuition is a Merging of the Understander with the Understood, Talk Delivered at Bloomberg, NYC, November 24 2009.

Unprecedented Stochastic Volatility and Systemic Shocks in Future Financial Market Behaviors?

Advanced Information Processing and Decision Making Strategies for Complex, Uncertain, and Radically Changing Networked Environments

A technical software engineering and modeling background as Finance-IT-Risk Management Practitioner in the Global Banking and Finance industry shaped the direction and focus of Yogesh Malhotra's interests. As a Global Financial Systems and Currency Arbitrage Systems Software Engineer and Management Consultant, he had the opportunity of designing, developing, programming, and implementing large-scale systems deployed by Worldwide Financial and Banking institutions. His primary interest from the beginning was however in strategic discontinuities characterizing global business and technology environments that represent greatest strategic opportunities as well as threats. For example, as one of first self-designed assignments as a newly recruited Programmer Analyst for Global Financial Systems, based upon a global survey of information technology trends, he presented his strategic plan for strategic dominance of [then] nascent Unix and C applications market to top corporate strategy executives at the world’s top-3 IT firm that relied primarily on hardware mainframe computers sales for its revenues and profits. This event occurred years before world's top IT firms such as IBM would make strategic moves into the Linux (an open-source variant of Unix) applications market space in the strategic shift from hardware mainframes to enterprise software applications.

Subsequent PhD helped advance his interest into basic research and rigorous statistical quantitative modeling on general system models and theoretical frameworks for designing complex self-adaptive systems that can withstand unforeseen and radical change, uncertainty, and complexity. His ground-breaking research on Knowledge Management focused on Advanced Information Processing and Decision Making Strategies for Complex, Uncertain, and Radically Changing Networked Environments. His research on Knowledge Management developed an overarching framework of "anticipation" of "surprises" [motivated by strategic thinking of Dr. Steven Kerr, CLO and Vice President at GE and subsequently CLO and Managing Director at Goldman Sachs] that are inherently unpredictable by extant mechanistic models of Information Systems and Financial Systems popular in mainstream research and practice. Radical discontinuities of such nature are considered highly improbable in terms of statistical probability models of natural sciences and popularized as extreme events after the Global Financial Crisis.

Given prior background and interests as Finance-IT-Risk Management Practitioner in complexity theory, cybernetics, and self-adaptive systems, his policy and strategy research and service have focused on integrative understanding of information theory, systems theory, systems dynamics, and control theory and their real world applications. His research on quantitative models followed the normative logical positivist focus that is typical of U.S. social sciences and business academia research. In contrast, his knowledge management research was stimulated by fascination with statistical outliers characterizing significant potential of learning: given their large variances from statistical averages. Studying such outliers seems critical for understanding future strategic discontinuities that may represent significant transitions having radical impact on the future worlds of business and technology. For instance, increased interconnectivity and complexity of networked global systems as in case of global financial markets may have significant implications in terms of future unprecedented stochastic volatility and systemic shocks which may not simply represent linear projections of the past.

In Company of Pioneers of Digital Future Defining Future of e-Business Models

"The wise see knowledge and action as one.” - Bhagvad-Gita

While holding the PhD fellowship and scholarship at the University of Pittsburgh, his digital social enterprise, was submitted as a last minute entry in the inaugural Industry.Net Online Achievement Awards. His digital enterprise was selected as the top nominee for 'Category 6 - Best Research Site' right behind Lycos search engine and right ahead of Alta Vista search engine in the Awards announced in Chicago on March 18, 1996. (Lycos and Alta Vista were the world's two most prominent WWW search engines years before Google arrived on the WWW landscape.) In 'Category 12 - Greatest Individual Contribution to Industry Online', Jim Clark followed by top nominee Mark Andreessen, the two pioneers who created the first commercial Web browser Netscape, led that category and were followed by Dr. Tim Berners-Lee, the British engineer and computer scientist and MIT professor credited with inventing the World Wide Web.

Among other U.S. CEOs and top corporate executives, Yogesh Malhotra has served as a Founding Member and Contributing Editor of the Ziff Davis Standard for Internet Commerce, as a Council Partner of the Inter-Agency Benchmarking & Best Practices Council of the U.S. Federal Government, and, as a member of the board of directors of the Knowledge Management Consortium International. Invitation from the Institute for Supply Management contributed to their first global membership cover story on Knowledge Management that focused on his knowledge management practices in the institute's flagship member publication. Invitation from the Global Center for Performance Excellence at the Conference Board resulted in his keynote presentation to the U.S. Quality Council flagship group comprised of top corporate executives from Malcolm Baldrige National Quality Award winning companies recognized as leaders in performance excellence and quality. Among other U.S. CEOs and top corporate executives, he has served on advisory boards and expert panels of several world renowned organizations and institutions with focus on advancing cutting-edge managerial understanding of information and communication technologies, and, knowledge management.

IT is about Managing Radical Discontinuous Change, Uncertainty, and Complexity

'The only Constant used to be Change... Even it is not Constant anymore...' - Yogesh Malhotra

Self-adaptive complex systems are based upon the premise of continuous self-learning and adaptation as he recognized early in practice. The academic discipline that taught the world about both 'information' and 'systems' wherein Yogesh Malhotra pursued practice-leading research to "bridge theory and practice" - an "ambitious undertaking" as described by Fortune magazine - seemed to have itself forgotten to adapt. He couldn't resist learning and adapting right ahead of the real world unfolding ahead.

Computerworld, the leading global trade journal of IT, selected his digital enterprise denoting the alternative hypothesis of Information Systems research as 'Best Site'. Information Week, the influential IT trade weekly would characterize his digital knowledge ventures as a "benchmark for practice". Their cutting-edge content written in blog format, long before blogs became popular, became a favorite of Harvard University professors across multiple schools and faculties. Harvard Business School MBA program professors used it for teaching Harvard MBAs and wrote about it as their favorite resource. Just word-of-mouth communications resulted in proactive adoption of his digital knowledge ventures at world's most leading-edge global institutions and elite business schools and libraries including Harvard, MIT, Wharton, Princeton, and, Stanford.

Forbes would characterize his 'digital lab' as "Tool for raising your company's IQ..." while Fortune would give a "Thumbs up for this serious surfer's tool useful for managers..." Business Week would call it the "Best business information source..." and "What every CEO should know." Wall Street Journal would applaud its focus on "Contemporary business, management and technology issues..." Its overarching Risk Management focus on self-adaptive complex systems wouldn't go unnoticed either. "Invaluable for applying complexity theory to business management..." would note New York Times while Wall Street Journal would admire their focus in terms of "Complexity theory made easy."

Long before extreme events and black swans became fashionable terms after the Global Financial Crisis, these tech ventures' focus on Knowledge Management as a discipline of systemic risk management for business environments characterized by radical discontinuous change would be established worldwide. "Perhaps the best KM resource site out there..." would proclaim KM World while Fast Company would review them as "Best sources for knowledge management and intellectual capital..." Wall Street Journal would call them "Probably the largest collection of knowledge management literature..." and InfoWorld would cover them as "Best web site on the topic of knowledge management..."

Computerworld would review them elsewhere as "Best site for information technology and business information..." and Information Week would call them "Unparalleled in depth and relevance for business research..." CIO Magazine would exclaim: "Wealth of incredibly rich, useful and interesting information..." while InfoWorld would call them "Best web sites for keeping up with hi-tech industry developments..." San Jose Mercury News put them "First on the list for company and industry research..." Wall Street Journal also reviewed them as "One of the best HR sites on the Internet..." Business 2.0 reviewed them as "Top frequently visited 'knowledge economy' sites..." Fast Company would deliver the review affirming the focus on most pragmatic and relevant research in noting that "If BRINT doesn't have it, then you probably don't need it..."

Pioneering Leading-Edge Research and Practices on Systemic Risk Management

Advanced Statistical and Quantitative Modeling of Information Processing and Decision Making Strategies and Behaviors in Complex, Uncertain, and Radically Changing Networked Environments

[Publications and Expert Panels] [Web of Science Citation Data]

Finance-IT-Risk Management Practitioner Yogesh Malhotra's peer-reviewed research publications on systemic risk management, controls, and compliance include two critically reviewed research monographs (Knowledge Management and Virtual Organizations, and, Knowledge Management and Business Model Innovation) that developed early thinking at the intersection of digital networks (e-Business) and digital assets (Knowledge Management), premier journal articles and conference proceedings, and, expert papers, encyclopedia and book chapters, and reprints. His ground-breaking research on Knowledge Management focused on Advanced Information Processing and Decision Making Strategies for Complex, Uncertain, and Radically Changing Networked Environments. In the context of Risk Management (Controls and Compliance), his empirical field research published in top-3 MIS journals and publications of ACM and IEEE has made ground-breaking contributions to Advanced Statistical and Quantitative Modeling of Information Processing and Decision Making Behaviors in Complex, Uncertain, and Radically Changing Networked Environments. His books and articles are frequently referenced in and influence policies, strategies, and practices of worldwide national governments, corporations, institutions, associations and other organizations across the world.

Ph.D. Fellowship from a Top-10 IT & Quantitative Methods Research Program

Finance-IT-Risk Management Practitioner Yogesh Malhotra earned a Ph.D. in Information Systems, Quantitative Methods, and, Statistics focused on WWW-based Networked Communication, Coordination, and Collaboration Systems from Katz Graduate School of Business at University of Pittsburgh (Top-10 Management Information Systems PhD Program, MIS Quarterly) with national honors on a doctoral fellowship and full scholarship. His Ph.D. thesis focused on empirical statistical quantitative modeling of operational risk management, controls, and compliance in WWW-based networked enterprise communication, coordination, and collaboration systems. In addition to his PhD thesis focus on operational risk management, his doctoral research focused on high impact original research on strategic and systemic risk management of radical discontinuous changes in business environments popularized as 'extreme events' and 'black swans' after the global financial crisis of 2008. His complementary research on the next-generation of self-adaptive systems focused on developing systems with capabilities for anticipation of surprise to address limitations in 'prediction' based on historical data. Original research on Knowledge Management as a discipline of detecting and pre-empting risks of systemic failures and radical discontinuities (aka 'extreme events') was inspired by discussions with senior professors at the University of Pittsburgh [University Professor Dr. William R. King (MIS chair), Robert W. Murphy Jr. Professor of Management Control Systems Dr. Jacob G. Birnberg (Management Control Systems chair), Dr. William N. Dunn (Knowledge Management), University Professor Dr. Ralph Kilmann (Knowledge Management), Dr. Louis A. Pingel (Quantitative Methods/Statistics) ]. His MIS-Control Systems-Quantitative Methods PhD thesis committee included MIS Thesis Chair Dr. Dennis Galletta, Management Control Systems chair Dr. Jacob G. Birnberg, and, other committee members: Dr. William N. Dunn (Knowledge Management), Dr. Chris F. Kemerer (MIS), and, Dr. Laurie J. Kirsch (MIS/Management Control Systems)).

* Reference: Ponzi, Leonard J. (IBM), Knowledge Management: Birth of a Discipline. In Michael E.D. Koenig & T. Kanti Srikantaiah (Eds.), Knowledge Management Lessons Learned: What Works and What Doesn't, (American Society for Information Science and Technology Monograph Series), 9-26, 2004.

** Reference: Subramani, M. and Nerur, S.P., 'Examining the Intellectual Structure of Knowledge Management, 1990-2002: An Author Co-citation Analysis.' University of Minnesota Management Information Systems Research Center Study. MISRC Working Paper #03-23, 2003.

*** Reference: Overmyer, Scott P., Survey about the most influential scholars-practitioners in Knowledge Management, ISWorld, 2000.

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