My Life as a Quant: Reflections on Physics and Finance
Physics and finance. What quants do. The Black-Scholes model. Quants and traders. Pure thought and beautiful mathematics can divine the laws of physics. Can they do the same for finance?
Chapter 1. Elective Affinities.
The attractions of science. The glory days of particle physics. Driven by ambitious dreams to Columbia. Legendary physicists and budding wunderkinder. Talent vs. character, plans vs. luck.
Chapter 2. Dog Years.
Life as a graduate student. Wonderful lectures. T.D. Lee, the brightest star in the firmament. Seven lean years. Getting out of graduate school, only half-alive.
Chapter 3. A Sort of Life.
The priesthood of itinerant postdocs. Research isn’t easy. Almost perishing, then publishing. The delirious thrill of collaboration and discovery.
Chapter 4. A Sentimental Education Oxford’s civilized charms. One physics paper leads to another. English idiosyncrasies. The anthroposophists.
Chapter 5. The Mandarins.
Research and parenthood on New York’s Upper East Side. A good life, but ... the difficulties of a two-career family.
Chapter 6. Knowledge of the Higher Worlds.
A two-city family. New age meditations. Karma. Goodbye to physics.
Chapter 7. In the Penal Colony.
The world of industry – working for money rather than love. The Business Analysis Systems Center at Bell Labs. A small part of a giant hierarchy. Creating software is beautiful.
Chapter 8. Stop-Time.
Wall Street beckons. Interviewing at investment banks. Leaving the Labs.
Chapter 9. Transformer.
The Financial Strategies Group at Goldman, Sachs & Co. Learning options theory. Becoming a quant. Interacting with traders. A new cast of characters.
Chapter 10. Easy Travel To Other Planets.
The history of options theory. Meeting and working with Fischer Black.The Black-Derman-Toy model.
Chapter 11. Force of Circumstance.
Manners and mores on Wall Street. The further adventures of some of my acquaintances. Volatility is infectious.
Chapter 12. A Severed Head.
A troubled year at Salomon Bros. Modeling mortgages. Salomon’s skill at quantitative marketing. Mercifully laid off.
Chapter 13. Civilization & Its Discontents.
Goldman as home. Heading the Quantitative Strategies Group. Equity derivatives. The Nikkei puts and exotic options. Nothing beats working closely with traders. Financial engineering becomes a real field.
Chapter 14. Laughter in the Dark.
The puzzle of the volatility smile. Beyond Black-Scholes: the race to develop local-volatility models of options. The right model is hard to find.
Chapter 15. The Snows of Yesteryear.
Wall Street consolidates. Clothing goes casual. I move from equity derivatives to firmwide risk. The bursting of the internet bubble. I take my leave.
Chapter 16. The Great Pretender.
Full circle, back to Columbia. Physics and finance redux. Different endeavors require different degrees of precision. Financial models as gedanken experiments.
"...tells wonderful stories of trying to bring higher mathematics to the Goldman Sachs equity-derivatives trading desk." (Grant's Interest Rate Observer, Dec. 17, 2004)
Not many Wall Street veterans could write: "Visiting clients in Madrid, I dropped into the Thyssen museum, where I stumbled across several [Arthur] Dove paintings . . . in The Hague, too, after a Euronext options conference, I saw early Mondrian paintings of lilies that were influenced by [Rudolf] Steiner".
There are few "gentlemen bankers" left these days. Nor is there much room in the great financial houses for anything that smacks of the amateur spirit. That is why Emanuel Derman's memoirs are so compelling. As a physicist with a PhD from Columbia University, New York, he was not exactly a natural born trader when he joined Goldman Sachs in 1985. He had spent most of the preceding 20 years in education and research.
But Derman got in at the ground floor of financial engineering, or quantitative finance, and spent two decades exploring the almost infinite potential (and complexity) of derivative products and sophisticated risk management. Now back in academia, Derman has reflected on his experiences of the past 40 years.
He begins his story in 1966, when he arrived in New York city from South Africa as a bewildered, rather lonely 20 year old. Derman's first degree in physics was from Cape Town university, but he had come to Columbia determined to make his name. "I dreamed of being another Einstein," he confesses. "I wanted to spend my life focusing on the discovery of truths that would live forever."
It took several years for Derman to accept that this ambition would not be realised. Pure physics had room at the top for only a handful of people. He struggled for years in a series of insecure post-doctoral positions. "In much the same way, by a process [that] option theorists call time decay," he writes, "financial stock options lose their potential as they approach their own expiration."
Derman's wry humour and sense of irony are apparent throughout the book. "If you didn't mind wasting the best years of your youth," he says, "graduate student life at Columbia was paradise." These qualities, allied to his many and varied literary and cultural references, reveal him as a multi-layered personality. In spite of his later eminence on The Street in the 1980s and 1990s, this is no crude Big Swinging Dick.
And he is not lying about wasting his youth. In 1969, when so many young people of his generation were heading off to hang out at Woodstock, Derman admits: "I spent the summer of 1969 at a particle physics summer school at Brookhaven National Laboratories in Upton, Long Island."
Eventually Derman abandoned pure physics for the - to him - less noble pursuit of applied physics, spending five years at AT&T's Bell Laboratories in New Jersey. This chapter, entitled "In the Penal Colony" - a reference to a Kafka short story of the same name - is a tale of corporate woe. The business world, while better paid than academia, seemed to offer even less satisfaction and excitement.
Derman says he learnt almost nothing about business or finance at AT&T, but he did learn to program and generally master the new generation of computers that were beginning to appear in the early 1980s. When the headhunter's call finally took him to Goldman Sachs's financial strategies group in December 1985, it came as an immense relief.
Derman was charged with developing the famous Black-Scholes option pricing model so it could be applied to bonds, an urgent task in the more volatile markets of the post oil shock world. Fischer Black, one of the original model's authors, worked at Goldman and became a mentor and inspiration to Derman. Black, he writes, "was genuinely in love with the idea of equilibrium." Derman was eventually to become co-author of the Black-Derman-Toy model, which priced bond options.
In total, Derman spent 16 years at Goldman, with one unhappy year at Salomon Brothers sandwiched in between. The former academic was not immune to the usual Wall Street temptation of leveraging a better deal at another firm. Nine months after September 11 2001, Derman left Goldman to return to Columbia, where he now leads the programme in financial engineering.
Derman was one of the heroes of risk management in the 1990s, constantly pushing at the boundaries of what was possible, coming up with ever more sophisticated and ingenious structures. And yet a sober scepticism, learned the hard way all those years ago in university libraries, underpins his world view.
He is sardonic about his work: "The capacity to wreak destruction with your models provides the ultimate respectability," he says. "Many of the Long Term Capital Management protagonists are back in business."
Now teaching again full time, Derman has grown even more sceptical. "A decade of speaking with traders and theorists has made me wonder what 'correct' means," he writes. "The more I look at the conflict between markets and theories, the more that limitations of models in the financial and human world become apparent to me." (Financial Times, November 18, 2004)
Indecisive, introspective, awkward, and sometimes morose, memoirist Emanuel Derman comes across like a character in a Saul Bellow novel. He wallows in loneliness after leaving his home in South Africa to earn a PhD in theoretical physics at Columbia University. Later, he obsesses over leaving pure physics to do applied research at Bell Laboratories. Then he punishes himself with guilt when he abandons physics entirely to work on Wall Street. Although he succeeds as a math-savvy "quant" at Goldman, Sachs & Co. (GS), he continues to ponder whether markets can really be understood. "We are still on a darkling plain," he writes toward the end of his new book. "If you are a theorist you must never forget that you are traveling through lawless roads where the local inhabitants don't respect your principles."
That sense of being an intruder in outlaw territory lends an intriguing mood to Derman's My Life As a Quant, a literate and entertaining memoir of his two-stage career -- in physics and then financial engineering. Wall Street looks quite different from a nerd's-eye view: "Geeks were fair game," Derman reflects. Once, a chief trader who passed between him and a fellow quant "winced, clutched his head with both hands as though in excruciating pain, and exclaimed, 'Aaarrggh-hhh! The force field! It's too intense! Let me out of the way!"'
As one of Wall Street's leading quants, Derman did throw off some intense gamma radiation. He worked at Goldman from 1985 until 2003 except for one year at Salomon Brothers. At Goldman, he moved from fixed income to equity derivatives to risk management, becoming a managing director in 1997. He co-invented a tool for pricing options on Treasury bonds, working with Goldman colleagues Bill Toy and the late Fischer Black, who co-invented the Black-Scholes formula for valuing options on stocks. Derman received the industry's "Financial Engineer of the Year" award in 2000. Now he directs the financial-engineering program at Columbia University.
Derman failed at what he really wanted, which was to become an important physicist. He was merely very smart in a field dominated by geniuses, so he kicked around from one low-paying research job to another. "At age 16 or 17, I had wanted to be another Einstein," he writes. "By 1976...I had reached the point where I merely envied the postdoc in the office next door because he had been invited to give a seminar in France." His move to Wall Street -- an acknowledgment of failure -- brought him financial rewards beyond the dreams of academic physicists and a fair measure of satisfaction as well.
In the tradition of the idiosyncratic memoir, My Life As a Quant is a grab bag of the author's interests. It quotes Schopenhauer and Goethe while supplying not one but three diagrams of a muon neutrino colliding with a proton. There is a long section on the brilliant and punctilious Fischer Black; a glimpse of physicist Richard Feynman; and an embarrassing encounter with finance giant Robert Merton, who sat next to the author on a long flight (Derman treated him rudely before realizing who he was).
Derman's mood seems to vary from bemused on good days to sour on bad ones. The chapter on his postdoc travels is titled "A Sort of Life"; his brief career at Bell Labs, "In the Penal Colony"; his tenure at Salomon Brothers, "A Severed Head." Pre-IPO Goldman Sachs comes off as relatively gentle yet stimulating. He writes: "It was the only place I never secretly hoped would crash and burn."
At times, his awkwardness is so extreme that it's funny. Here's how he failed to work up his nerve to ask a Columbia professor to be his adviser: "Every time I saw him I smiled; every time I smiled he bared his lips back at me with greater awkwardness." It got so painful that he began to flee whenever he saw the prof coming.
The most challenging part of the book -- and for techies, probably the best -- is Derman's detailed explanation of trading tools he developed. The Black-Derman-Toy model, from 1986, allowed trading desks to come up with prices for Treasury bond options based on math rather than guesswork. In 1993 he and Goldman colleague Iraj Kani invented an options-pricing method that improved on an aspect of Black-Scholes -- its incorrect assumption that the volatility of options is unvarying. They deduced the "local" volatility of a conventional option at each possible stock price and at each moment up to expiration. That information could then be used to price exotic options more accurately.
As it turned out, both inventions had limitations in practice, but Derman accepts that. The theoretical purist finds a measure of contentment in contributing to the imprecise world of finance -- "intuiting, inventing, or concocting approximate laws and patterns." It ain't E=mc2, but as he recognizes, it may be the best anyone can hope for. By Peter Coy (Business Week, November 15, 2004)
"Sadly, there's not much to buy in the stock or bond market this holiday season, but John Wiley & Sons has published the perfect gift. "My Life as a Quant," by Emanuel Derman (292 pages, $29.95) is, indeed, a perfect memoir, as Derman, a South African-born physicist turned financial engineer, is a perfect memoirist."--Grant's Interest Rate Observer