Derivatives traders and institutions today rely extensively on the use of mathematical models in deciding when, how, and how much to trade. Some of these models are public knowledge and near-universal in their application, the best example being the Black–Scholes options pricing model which is used to determine the ‘right’ premium to be charged for an option. Others are proprietary and used within individual institutions to help them decide on the kinds of trades they will undertake. This chapter examines some of the effects that the use of models has on the derivatives markets.

Quantitative modelling in economics is by no means a special feature of derivatives markets. Macro-econometric models and growth models (among others) have been around for many years. The Feldman–Mahalanobis growth model was the basis of India's early efforts at planned economic growth during the Second Five Year plan (1952). However, because of the unrealism of their assumptions, ‘analysis based on traditional macro-econometric models has disappeared from the peer-reviewed academic literature of the past thirty years.’ Kling considered macro-econometric models to be inherently unscientific because ‘unlike the objects of controlled experimentation, real-world events are often unique and non-repeatable’ and dubbed macro-econometrics ‘the science of hubris’.

Models are however extremely important in derivatives markets. Apart from their use in decision-taking for traders, models are also used to determine the market values of financial instruments and to estimate unrealized gains and losses for the purpose of periodic financial statements, published as well as internal. The general accounting principle followed for financial instruments for balance sheets is that of ‘fair value’ which usually approximates to the common sense understanding of ‘market value’.