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The Physics of Wall Street: A Brief History of Predicting the Unpredictable by James Owen Weatherall
Albert Einstein, algorithmic trading, Antoine Gombaud: Chevalier de Méré, Asian financial crisis, bank run, Benoit Mandelbrot, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, butterfly effect, capital asset pricing model, Carmen Reinhart, Claude Shannon: information theory, collateralized debt obligation, collective bargaining, dark matter, Edward Lorenz: Chaos theory, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial innovation, George Akerlof, Gerolamo Cardano, Henri Poincaré, invisible hand, Isaac Newton, iterative process, John Nash: game theory, Kenneth Rogoff, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, martingale, new economy, Paul Lévy, prediction markets, probability theory / Blaise Pascal / Pierre de Fermat, quantitative trading / quantitative ﬁnance, random walk, Renaissance Technologies, risk-adjusted returns, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Coase, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, statistical arbitrage, statistical model, stochastic process, The Chicago School, The Myth of the Rational Market, tulip mania, V2 rocket, volatility smile
Princeton, NJ: Princeton University Press. Davis, Monte. 1984. “Benoît Mandelbrot.” Omni Magazine 6 (5): 64. Davy, P. H., A. Sornette, and D. Sornette. 1990. “Some Consequences of a Proposed Fractal Nature of Continental Faulting.” Nature 348 (November): 56–58. Derman, Emanuel. 2004. My Life as a Quant. Hoboken, NJ: John Wiley and Sons. — — — . 2011a. “Emanuel Derman on Fischer Black.” Available at https://www.quantnet.com/emanuel-derman-fischer-black/. — — — . 2011b. Models Behaving Badly. New York: Free Press. Derman, Emanuel, and Iraj Kani. 1994. “The Volatility Smile and Its Implied Tree.” Goldman Sachs Quantitative Strategies Research Note. Derman, Emanuel, and Nassim Nicholas Taleb. 2005. “The Illusions of Dynamic Replication.” Quantitative Finance (4): 323–26. Derman, Emanuel, and Paul Wilmott. 2009.
The success of the Apollo 11 mission gave Nixon an excuse to divert funds from NASA and other research groups to the military effort. By 1971, NASA’s budget was less than half of what it had been in 1966 (in real terms). Meanwhile, college enrollment began to drop, largely because the Baby Boom years were over. Once the “Boomers” had graduated, universities stopped hiring new faculty members. Emanuel Derman was a South African physicist who experienced this funding roller coaster firsthand. He entered graduate school, at Columbia University, in 1966, at the high point of U.S. science funding. He worked on experimental particle physics — a field far from NASA’s central interests, but a beneficiary of the uptick in government support for physics nonetheless. Like most graduate students, he slogged through, living on a small stipend and working long hours.
Whereas in the years leading up to the crash the Black-Scholes model seemed to get options prices exactly right, in virtually all contexts and all markets, after the crash certain discrepancies began to appear. These discrepancies are often called the volatility smile because of their distinctive shape in certain graphs. The smile appeared suddenly and presented a major mystery for financial engineers in the early 1990s, when its prevalence was first recognized. Notably, Emanuel Derman came up with a way of modifying the Black-Scholes model to account for the volatility smile, though he never came up with a principled reason why the Black-Scholes model had stopped working. Mandelbrot’s work, however, offers a compelling explanation for the volatility smile. One way of interpreting the smile is as an indication that the market believes large shifts in prices are more likely than the Black-Scholes model assumes.
Albert Einstein, Asian financial crisis, Augustin-Louis Cauchy, Black-Scholes formula, British Empire, Brownian motion, capital asset pricing model, Cepheid variable, crony capitalism, diversified portfolio, Douglas Hofstadter, Emanuel Derman, Eugene Fama: efficient market hypothesis, Henri Poincaré, Isaac Newton, law of one price, Mikhail Gorbachev, quantitative trading / quantitative ﬁnance, random walk, Richard Feynman, Richard Feynman, riskless arbitrage, savings glut, Schrödinger's Cat, Sharpe ratio, stochastic volatility, the scientific method, washing machines reduced drudgery, yield curve
THE FINANCIAL MODELERS’ MANIFESTO AN ETHICAL COROLLARY MARKETS AND MORALS TAT TV AM ASI Appendix Acknowledgments Notes Index About the Author ALSO BY EMANUEL DERMAN My Life as a Quant: Reflections on Physics and Finance This edition first published in 2011 Copyright © 2011 by Emanuel Derman Registered office John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please see our website at www.wiley.com. The right of Emanuel Derman to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act 1988. First published in the United States by Free Press, A Division of Simon & Schuster, Inc.
Knight, Risk, Uncertainty, and Profit (Houghton Mifflin,1921). 7. See D. A. Freedman and P. B. Stark, “What Is the Chance of an Earthquake?” University of California, Berkeley, Department of Statistics, Technical Report 611, January 2003. 8. In mathematics the symbol A (Delta) before any other symbol indicates an infinitesimally small change in the quantity represented by the second symbol. Thus At is an arbitrarily small increment in time. 9. See Emanuel Derman, “The Perception of Time, Risk and Return During Periods of Speculation,” Quantitative Finance 2, no. 4 (2002): 282–96. 10. “Exclusive” in describing an apartment means desirable and expensive because it excludes many people. In a financial crisis, though, exclusivity means illiquidity. What you want to own in a widespread financial crunch are inclusive securities. 11. I use the Greek letter omega, pronounced “oh-mega,” to quantify deliciousness. 12.
Thought: Extension and three meta-affects time Tomonaga, Shin’ichiro transparency: ethics of designing financial products and Treasury bills Treasury bonds Treynor, Jack Trumpeldor, Yosef truth uncertainty: EMM and financial models and physics and quantifiable risk and theory and unquantifiable of value unconscious underliers understanding: action and of adequate causes of body of experience intuition and of passions self- will and of world Universal Law of Gravitation (Newton) universe, laws of the University of Cape Town untouchables utility functions utility stocks value: benefits of financial models and Black-Scholes Model and definition of determination of EMM and estimates of financial markets and financial models and Law of One Price and mysteries of the world and determining price and purpose of finance models and ranking of securities by uncertainty of and universal value for risk and valuing of options vulgarity of financial models and vanilla options volatility: benefits of financial models and Black-Scholes Model and CAPM and EMM and financial models and futility of using financial models and purpose of finance models and risk and stochastic vulgarity of financial models and Volta, Alessandro voltaic pile W-bosons War of Independence, Israeli waves: electromagnetic theory and weather models Weinberg-Salam Model Weinberg, Steven Wells, Robin will Wilmott, Paul The Wind in the Willow (Grahame) wonder: Spinoza’s emotions theory and words: limitations of world: composition of as focus of physics intuition as way of understanding the invention/discovery as synthesis of mind and mysteries of World War II. See Second World War/ World War II worth: definition of Yahweh, Z-bosons Zionism Zippy model airplane About The Author Emanuel Derman is head of risk at Prisma Capital Partners and a professor at Columbia University, where he directs the program in financial engineering. He is the author of My Life as a Quant, one of Businessweek's top ten books of the year, in which he introduced the quant world to a wide audience. He was born in South Africa but has spent most of his professional life in New York City, where he has made contributions to several fields.
The Quants by Scott Patterson
Albert Einstein, asset allocation, automated trading system, Benoit Mandelbrot, Bernie Madoff, Bernie Sanders, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, buttonwood tree, buy low sell high, capital asset pricing model, centralized clearinghouse, Claude Shannon: information theory, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, Doomsday Clock, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, Gordon Gekko, greed is good, Haight Ashbury, index fund, invention of the telegraph, invisible hand, Isaac Newton, job automation, John Nash: game theory, law of one price, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, merger arbitrage, NetJets, new economy, offshore financial centre, Paul Lévy, Ponzi scheme, quantitative hedge fund, quantitative trading / quantitative ﬁnance, race to the bottom, random walk, Renaissance Technologies, risk-adjusted returns, Rod Stewart played at Stephen Schwarzman birthday party, Ronald Reagan, Sergey Aleynikov, short selling, South Sea Bubble, speech recognition, statistical arbitrage, The Chicago School, The Great Moderation, The Predators' Ball, too big to fail, transaction costs, value at risk, volatility smile, yield curve, éminence grise
They never got over the fear. The volatility smile persists to this day. The volatility smile perplexed Wall Street’s quants. For one thing, it made a hash of their carefully calibrated hedging strategies. It also raised questions about the underlying theory itself. “I realized that the existence of the smile was completely at odds with Black and Scholes’s 20-year-old foundation of options theory,” wrote Emanuel Derman, a longtime financial engineer who worked alongside Fischer Black at Goldman Sachs, in his book My Life as a Quant. “And, if the Black-Scholes formula was wrong, then so was the predicted sensitivity of an option’s price to movements in its underlying index. … The smile, therefore, poked a small hole deep into the dike of theory that sheltered options trading.” Black Monday did more than that.
It was a race against time, and he’d lost. The mad scientists who’d been running wild in the heart of the financial system for decades had finally done it: they’d blown it up. On a frigid day in early January 2009, several weeks after addressing the crowd of hopeful quants at the Renaissance Hotel, Wilmott boarded a plane at Heathrow Airport in London and returned to New York City. In New York, he met with über-quant Emanuel Derman. A lanky, white-haired South African, Derman headed up Columbia University’s financial engineering program. He was one of the original quants on Wall Street and had spent decades designing derivatives for Goldman Sachs, working alongside legends such as Fischer Black. Wilmott and Derman had become alarmed by the chaotic state of their profession and by the mind-boggling destruction it had helped bring about.
“Even if one were to have lived”: The age of the universe is 13.5 billion years, not 20 billion. When German tanks rumbled into France: Some details of Mandelbrot’s life come from a series of interviews with Mandelbrot in the summer of 2008. Many also come from the book The (Mis)Behavior of Markets: A Fractal View of Financial Turbulence, by Benoit Mandelbrot and Richard L. Hudson (Basic Books, 2006). “I realized that the existence of the smile”: My Life as a Quant, by Emanuel Derman (John Wiley & Sons, 2004), 226. A squad of fifty armed federal marshals: Certain details come from Den of Thieves, by James Stewart (Simon & Schuster, 1991). He also worked as a consultant: I learned the fascinating story of Thorp’s discovery of the Madoff fraud in several interviews with Thorp in December 2008 as the fraud was discovered. I confirmed his story with the firm involved and through several pertinent documents. 5 FOUR OF A KIND In 1990, Ed Thorp took a call: The details of Thorp’s connection to Citadel was told to me by Thorp, Frank Meyer, Justin Adams, and Ken Griffin.
How I Became a Quant: Insights From 25 of Wall Street's Elite by Richard R. Lindsey, Barry Schachter
Albert Einstein, algorithmic trading, Andrew Wiles, Antoine Gombaud: Chevalier de Méré, asset allocation, asset-backed security, backtesting, bank run, banking crisis, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, business process, buy low sell high, capital asset pricing model, centre right, collateralized debt obligation, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, discounted cash flows, disintermediation, diversification, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, full employment, George Akerlof, Gordon Gekko, hiring and firing, implied volatility, index fund, interest rate derivative, interest rate swap, John von Neumann, linear programming, Loma Prieta earthquake, Long Term Capital Management, margin call, market friction, market microstructure, martingale, merger arbitrage, Nick Leeson, P = NP, pattern recognition, pensions crisis, performance metric, prediction markets, profit maximization, purchasing power parity, quantitative trading / quantitative ﬁnance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Richard Feynman, Richard Feynman, Richard Stallman, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, sorting algorithm, statistical arbitrage, statistical model, stem cell, Steven Levy, stochastic process, systematic trading, technology bubble, The Great Moderation, the scientific method, too big to fail, trade route, transaction costs, transfer pricing, value at risk, volatility smile, Wiener process, yield curve, young professional
The level of abstractness involved in this work frequently inspires awe, fear, and even derision among nonquants. Consider this quotation from Time magazine of April 1994, cited by Peter Bernstein: “Prices of derivatives are not based on old-fashioned human hunches but on calculations designed and monitored by computer wizards using abstruse mathematical formulas . . . developed by so-called quants . . . ”2 Wizards, indeed. Even Emanuel Derman, one of the most famous of quants, feels compelled to assert that “[t]he Black-Scholes model tells us, almost miraculously, how to manufacture an option . . . ”3 (italics added). As the knowledge necessary to perform such feats is not a part of the regular secondary-school math curriculum, facility with derivatives requires a level of quantitative (hence “quant”) training and skill confined to the mathematical specialist.
What I did was show that if you could replicate a security with another with an arbitrarily high degree of probability, then you could obtain pricing formulas that had all the good properties associated with perfect replication. In the paper in question, I showed that you could price options assuming the underlying stock followed a Poisson process. Later I showed with Michael Ong that this could be used to “correctly” price binary options using call spreads.16 JWPR007-Lindsey May 7, 2007 16:55 Neil Chriss 123 I wanted to get feedback on my paper and so I sent it around to various academics and also to Emanuel Derman, who was head of Goldman Sachs’ Quantitative Strategies Group, which was the leading group in derivatives pricing research at the time. Derman’s group was in charge of derivatives research and technology, and he was the most recognized figure in the industry at the time. One day, while sitting around IAS, Emanuel called me to tell me he had received my paper. He told me that he had a regular seminar invited me to come in and give a presentation to his group on my paper in an informal seminar he ran.
While I was still at First Boston, the head of equity research asked me to give a guest lecture in his course at Columbia. I loved it. I taught a course of my own at Columbia in the mid 1980s and then started teaching as an adjunct at Yale. At Yale I had the pleasure over 15 years of coteaching with both my early mentor, Martin Shubik, and later my former Yale classmate but now well-known professor Will Goetzmann. In 2005, I returned to teach at Columbia at the encouragement of Emanuel Derman, along with Leon Metzger. In the early 1990s Jack Marshall and Bob Schwartz asked me to become involved in a professional society they were then organizing, the International Association of Financial Engineers. I was enthusiastic about being a part of that organization as I love everything about financial engineering. Eventually, I served as Chair of the Executive Board, and I am still very much involved with their work as a Director and co-Chair of the Investor Risk Committee.
Nerds on Wall Street: Math, Machines and Wired Markets by David J. Leinweber
AI winter, algorithmic trading, asset allocation, banking crisis, barriers to entry, Big bang: deregulation of the City of London, butterfly effect, buttonwood tree, buy low sell high, capital asset pricing model, citizen journalism, collateralized debt obligation, corporate governance, Craig Reynolds: boids flock, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Danny Hillis, demand response, disintermediation, distributed generation, diversification, diversified portfolio, Emanuel Derman, en.wikipedia.org, experimental economics, financial innovation, Gordon Gekko, implied volatility, index arbitrage, index fund, information retrieval, Internet Archive, John Nash: game theory, Khan Academy, load shedding, Long Term Capital Management, Machine translation of "The spirit is willing, but the flesh is weak." to Russian and back, market fragmentation, market microstructure, Mars Rover, moral hazard, mutually assured destruction, natural language processing, Network effects, optical character recognition, paper trading, passive investing, pez dispenser, phenotype, prediction markets, quantitative hedge fund, quantitative trading / quantitative ﬁnance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Renaissance Technologies, Richard Stallman, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, semantic web, Sharpe ratio, short selling, Silicon Valley, Small Order Execution System, smart grid, smart meter, social web, South Sea Bubble, statistical arbitrage, statistical model, Steve Jobs, Steven Levy, Tacoma Narrows Bridge, the scientific method, The Wisdom of Crowds, time value of money, too big to fail, transaction costs, Turing machine, Upton Sinclair, value at risk, Vernor Vinge, yield curve, Yogi Berra
No one does a free chapter for Another Bunch of Middle-Aged Financial Guys. The other people writing for the book included some of the smartest kids on the block and some old friends, so I said yes on the spot. There are chapters by pillars of the quant world, authors of the standard texts, and writers of oft-cited papers. Others did interesting and rewarding things with technology and markets. Emanuel Derman, author of My Life as a Quant: Reflections on Physics and Finance ( John Wiley & Sons, 2004), made this point in the first line of his review for the Wall Street Journal: “By my reckoning, several of the 25 memoirists in How I Became a Quant are not true quants, and they are honest (or proud) enough to admit it.”2 xv xvi Introduction I am, no doubt, high on the list of poseurs, and I will be the first to admit it.
Someday soon you’ll point your handheld’s camera at the book and it will use OCR (optical character recognition) to find (or offer to sell you) the material you’re looking for. Absent that fancy gadget, try the web site NerdsonWallStreet.com. It has links in to all of these references, plus color and animated versions of the black & white screen grabs found in the book. The site will be updated often with new and topical items. Notes 1. A term of respect popularized by Michael Lewis in his 1989 book, Liar’s Poker (W.W. Norton). 2. Emanuel Derman, “Finance by the Numbers,” Wall Street Journal, August 22, 2007. 3. Much of Steven Levy’s 1984 book Hackers: Heroes of the Computer Revolution (Doubleday) takes place in the PDP-1 lab at MIT. Hacking had no criminal connotation at the time. The book is still in print. 4. Start with Herman Kahn’s On Thermonuclear War (Princeton, NJ: Princeton University Press, 1960) for a weighty tome, or “How RAND Invented the Postwar World,” by Virginia Campbell, in Invention & Technology magazine (Summer 2004) for a much more compact read. 5.
Steve Snider, who manages multibillion-dollar institutional portfolios at Fidelity, makes the point that “classical methods of data analysis assume that there is a stable process generating the data, so it is valid to attempt to deduce the underlying process from a selection of known observations. These new techniques don’t require that assumption, so they may be useful in especially noisy systems like stock forecasting.”5 That said, the dangers of rampant data mining using many of these approaches cannot be overemphasized (see Chapter 6, “Stupid Data Miner Tricks”). Emanuel Derman, former head of quantitative strategies at Goldman Sachs, described this over eagerness to blindly apply quantitative and computerized methods: The best quantitative finance brings real insight into the relation between value and uncertainty, and it approaches the quality of real science; the worst is a pseudoscientific hodgepodge of complex mathematics used with obscure justification.6 The Crackpot as Billionaire Not everyone who decides to burn CPU cycles on Wall Street ends up writing about lessons learned.
Affordable Care Act / Obamacare, Bernie Madoff, big data - Walmart - Pop Tarts, call centre, carried interest, cloud computing, collateralized debt obligation, correlation does not imply causation, Credit Default Swap, credit default swaps / collateralized debt obligations, crowdsourcing, Emanuel Derman, housing crisis, illegal immigration, Internet of things, late fees, medical bankruptcy, Moneyball by Michael Lewis explains big data, new economy, obamacare, Occupy movement, offshore financial centre, payday loans, peer-to-peer lending, Peter Thiel, Ponzi scheme, prediction markets, price discrimination, quantitative hedge fund, Ralph Nader, RAND corporation, recommendation engine, Sharpe ratio, statistical model, Tim Cook: Apple, too big to fail, Unsafe at Any Speed, Upton Sinclair, Watson beat the top human players on Jeopardy!, working poor
Few of us would want to return to a time before they existed. How do we start to regulate the mathematical models that run more and more of our lives? I would suggest that the process begin with the modelers themselves. Like doctors, data scientists should pledge a Hippocratic Oath, one that focuses on the possible misuses and misinterpretations of their models. Following the market crash of 2008, two financial engineers, Emanuel Derman and Paul Wilmott, drew up such an oath. It reads: ~ I will remember that I didn’t make the world, and it doesn’t satisfy my equations. ~ Though I will use models boldly to estimate value, I will not be overly impressed by mathematics. ~ I will never sacrifice reality for elegance without explaining why I have done so. ~ Nor will I give the people who use my model false comfort about its accuracy.
Apple, the most valuable company: Verne Kopytoff, “Apple: The First $700 Billion Company,” Fortune, February 10, 2015, http://fortune.com/2015/02/10/apple-the-first-700-billion-company/. In 1907 alone, 3,242 miners died: MSHA, “Coal Fatalities for 1900 Through 2014,” US Department of Labor, accessed January 9, 2016, www.msha.gov/stats/centurystats/coalstats.asp. drew up such an oath: Emanuel Derman and Paul Wilmott, “The Financial Modeler’s Manifesto,” January 7, 2009, www.uio.no/studier/emner/sv/oekonomi/ECON4135/h09/undervisningsmateriale/FinancialModelersManifesto.pdf. FindFamilyResources: FindFamilyResources website, accessed January 9, 2016, http://findfamilyresources.com/. If you plot year-to-year scores on a chart: Gary Rubinstein, “Analyzing Released NYC Value-Added Data Part 2,” Gary Rubinstein’s Blog, February 28, 2012, http://garyrubinstein.teachforus.org/2012/02/28/analyzing-released-nyc-value-added-data-part2/.
3D printing, accounting loophole / creative accounting, additive manufacturing, Airbnb, algorithmic trading, Asian financial crisis, asset allocation, bank run, Basel III, bonus culture, Bretton Woods, British Empire, call centre, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, carried interest, centralized clearinghouse, clean water, collateralized debt obligation, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, crowdsourcing, David Graeber, deskilling, Detroit bankruptcy, diversification, Double Irish / Dutch Sandwich, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial deregulation, financial intermediation, Frederick Winslow Taylor, George Akerlof, gig economy, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, High speed trading, Home mortgage interest deduction, housing crisis, Howard Rheingold, Hyman Minsky, income inequality, index fund, interest rate derivative, interest rate swap, Internet of things, invisible hand, joint-stock company, joint-stock limited liability company, Kenneth Rogoff, knowledge economy, labor-force participation, labour mobility, London Whale, Long Term Capital Management, manufacturing employment, market design, Martin Wolf, moral hazard, mortgage debt, mortgage tax deduction, new economy, non-tariff barriers, offshore financial centre, oil shock, passive investing, pensions crisis, Ponzi scheme, principal–agent problem, quantitative easing, quantitative trading / quantitative ﬁnance, race to the bottom, Ralph Nader, Rana Plaza, RAND corporation, random walk, rent control, Robert Shiller, Robert Shiller, Ronald Reagan, Second Machine Age, shareholder value, sharing economy, Silicon Valley, Silicon Valley startup, Snapchat, sovereign wealth fund, Steve Jobs, technology bubble, The Chicago School, The Spirit Level, The Wealth of Nations by Adam Smith, Tim Cook: Apple, Tobin tax, too big to fail, trickle-down economics, Tyler Cowen: Great Stagnation, Vanguard fund
Markowitz’s quantitative finance methodology won him the Nobel Prize and became the basis of the first computerized arbitrage-trading program, which would eventually take over the markets. Today 70–80 percent of all trading is done by computers, much of it using flash programs designed to trade on fractional price changes over split-second time intervals, reducing the average holding period of a stock from about eight years in the 1960s to just four months by 2012.55 Emanuel Derman, a quantitative mathematician and physicist who pioneered some of those trading models at Goldman and now teaches financial engineering at Columbia, believes that the focus on mathematical economics in both finance and business education has gone way too far. Indeed, in 2012, he published a mea culpa for his own work in the twentieth-anniversary issue of the Journal of Derivatives. “Models of all kinds, ethical and quantitative too, have been behaving very badly,” he wrote.
I must also thank the many other important people who gave their valuable time to sit for interviews and share their thoughts—among them are Senator Elizabeth Warren, Senator Sherrod Brown, Gary Gensler, Damon Silvers, Warren Buffett, Jack Bogle, Andy Haldane, Lord Adair Turner, Richard Trumka, William Lazonick, Mike Konczal, Nell Abernathy, Felicia Wong, Anat Admati, Gerald Davis, Stephen Cecchetti, James Galbraith, Edmund Phelps, Wallace Turbeville, Thomas Hoenig, Charles Morris, Joe Nocera, Charles Ferguson, Bob Lutz, Lisa Donner, Rebecca Henderson, Margaret Heffernan, Andrew Lo, Dominic Barton, Nitin Nohria, Rakesh Khurana, Emanuel Derman, Mark Bertolini, Andrew Smithers, Lynn Stout, Sam Palmisano, Greg Smith, Joseph Blasi, David Rothkopf, Ken Miller, Marc Fasteau, Robert R. Locke, Ruchir Sharma, Gautam Mukunda, Saule Omarova, Eileen Appelbaum, and Sherle Schwenninger. Thanks also to the many academics and policy thinkers whose research I relied heavily on, including but not limited to: Greta Krippner, Moritz Schularick, Alan M.
Goldman Sachs Global Markets Institute, “How Capital Markets Enhance Economic Performance and Facilitate Job Creation,” by William C. Dudley and R. Glenn Hubbard, November 2004. 54. Khurana, From Higher Aims to Hired Hands, 346. 55. Jesse Eisinger, “Challenging the Long-Held Belief in ‘Shareholder Value,’ ” New York Times, June 27, 2012. Also see LPL Financial Research, “Weekly Market Commentary,” by Jeffrey Kleintop, CFA, August 6, 2012. 56. Emanuel Derman, “Apologia Pro Vita Sua,” Journal of Derivatives 20, no. 1 (2012). 57. Author interview with Nitin Nohria, dean of Harvard Business School, for this book. 58. “MIT Facts 2016: MIT Students After Graduation,” Massachusetts Institute of Technology, online at http://web.mit.edu/facts/alum.html. 59. Author interview with Smith for this book. 60. Henry Sanderson and Neil Hume, “China Funds Bring Chaos to Metals Markets,” Financial Times, January 15, 2015; Gregory Meyer, “Bunge Says China Lenders Distorting Soybean Trade,” Financial Times, February 12, 2015; author interview with Derman for this book, 2015. 61.
Extreme Money: Masters of the Universe and the Cult of Risk by Satyajit Das
affirmative action, Albert Einstein, algorithmic trading, Andy Kessler, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Basel III, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, BRICs, British Empire, capital asset pricing model, Carmen Reinhart, carried interest, Celtic Tiger, clean water, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, debt deflation, Deng Xiaoping, deskilling, discrete time, diversification, diversified portfolio, Doomsday Clock, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, eurozone crisis, Fall of the Berlin Wall, financial independence, financial innovation, fixed income, full employment, global reserve currency, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, happiness index / gross national happiness, haute cuisine, high net worth, Hyman Minsky, index fund, interest rate swap, invention of the wheel, invisible hand, Isaac Newton, job automation, Johann Wolfgang von Goethe, joint-stock company, Joseph Schumpeter, Kenneth Rogoff, Kevin Kelly, labour market flexibility, laissez-faire capitalism, load shedding, locking in a profit, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Martin Wolf, merger arbitrage, Mikhail Gorbachev, Milgram experiment, Mont Pelerin Society, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, Naomi Klein, Network effects, new economy, Nick Leeson, Nixon shock, Northern Rock, nuclear winter, oil shock, Own Your Own Home, pets.com, Plutocrats, plutocrats, Ponzi scheme, price anchoring, price stability, profit maximization, quantitative easing, quantitative trading / quantitative ﬁnance, Ralph Nader, RAND corporation, random walk, Ray Kurzweil, regulatory arbitrage, rent control, rent-seeking, reserve currency, Richard Feynman, Richard Feynman, Richard Thaler, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, Rod Stewart played at Stephen Schwarzman birthday party, rolodex, Ronald Reagan, Ronald Reagan: Tear down this wall, savings glut, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, Slavoj Žižek, South Sea Bubble, special economic zone, statistical model, Stephen Hawking, Steve Jobs, The Chicago School, The Great Moderation, the market place, the medium is the message, The Myth of the Rational Market, The Nature of the Firm, The Predators' Ball, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, trickle-down economics, Turing test, Upton Sinclair, value at risk, Yogi Berra, zero-coupon bond
Sylvain Raines, an experienced quant, joked that quantitative finance was an oxymoron as “finance is quantitative by definition...this is like saying aerial flight or wet swimming.”11 Newly graduated financial experts applied simple “phenomenological toys” to markets. Most financial models are wrong, only the degree of error is in question. Differential equations, positive definite matrices or the desirable statistical properties of an estimator rarely determine the price of traded financial instruments. Goldman Sachs’ Emanuel Derman, a trained physicist, identified the difference: “In physics, a model is correct if it predicts the future trajectories of planets or the existence and properties of new planets.... In finance, you cannot easily prove a model right by such observations.” Derman ruefully concluded: “Trained economists have never seen a really first-class model.”12 Commenting on the required level of quantitative knowledge of people involved in financial markets, Derman once observed that Tour de France bicyclists did not need to know the laws of physics.
Skeel Jr and Frank Partnoy “The promise and perils of credit derivatives” (2007) University of Cincinnati Law Review 75: 1019. 28. www.derivativesstrategy.com/magazine/archive/1999/0899qa.asp 29. Ian Kerr referred to them as Chernobyl decay obligations (www.efinancialnews.com/homepage/content/2448260317). Chapter 13—Risk Supermarkets 1. Peter L. Bernstein (1996) Against The Gods: The Remarkable Story of Risk, John Wiley, New York: 1. 2. Jorge Luis Borges (1999) Collected Fiction, Penguin Books, New York: 105. 3. Emanuel Derman (2004) My Life As A Quant: Reflection on Physics and Finance, John Wiley, New Jersey. 4. Berkshire Hathaway Letter to Shareholders (2002). 5. Martin Z. Braun, Darrell Preston and Liz Willen “The banks that fleeced Alabama” (September 2005) Bloomberg Markets; William Selway and Martin Z. Braun “The fleecing of Alabama: the bills come due” (July 2008) Bloomberg Markets. 6. In a Dutch auction, the auctioneer begins with a high asking price that is lowered until some bidder accepts the auctioneer’s price, or a predetermined reserve price (the seller’s minimum acceptable price) is reached.
The term was coined by Philip Delves Broughton (2009) Ahead of the Curve: Two Years at Harvard Business School, Penguin Books, New York. 8. Ibid: 50. 9. Rahul Bajaj “The privilege of living in extraordinary times” (26 January 2009) Financial Times. 10. Stephen Crittenden “Background briefing, mostly bloody awful” (29 March 2009), ABC Radio, Australia. 11. Sylvain Raynes “The state of financial engineering” (3 December 2008) (www.quantnet.com/forum/showthread.php?t=3978). 12. Emanuel Derman (2004) My Life as a Quant: Reflections on Physics and Finance, John Wiley, New Jersey: 266, 267. 13. “Prophet of climate doom a scientific black sheep” (17 September 2009), AFP (www.terradaily.com/reports/Prophet_of_climate_doom_a_scientific_black_sheep_999.html). 14. Lewis Carroll (1960) The Annotated Alice: Alice’s Adventures in Wonderland, Penguin Books, London: 129. 15. Derman, My Life as a Quant: 266, 267. 16.
A Declaration of the Independence of Cyberspace, Albert Einstein, AltaVista, Amazon Mechanical Turk, Asperger Syndrome, availability heuristic, Benoit Mandelbrot, biofilm, Black Swan, British Empire, conceptual framework, corporate governance, Danny Hillis, Douglas Engelbart, Emanuel Derman, epigenetics, Flynn Effect, Frank Gehry, Google Earth, hive mind, Howard Rheingold, index card, information retrieval, Internet Archive, invention of writing, Jane Jacobs, Jaron Lanier, Kevin Kelly, lone genius, loss aversion, mandelbrot fractal, Marshall McLuhan, Menlo Park, meta analysis, meta-analysis, New Journalism, Nicholas Carr, out of africa, Ponzi scheme, pre–internet, Richard Feynman, Richard Feynman, Rodney Brooks, Ronald Reagan, Schrödinger's Cat, Search for Extraterrestrial Intelligence, SETI@home, Silicon Valley, Skype, slashdot, smart grid, social graph, social software, social web, Stephen Hawking, Steve Wozniak, Steven Pinker, Stewart Brand, Ted Nelson, telepresence, the medium is the message, the scientific method, The Wealth of Nations by Adam Smith, theory of mind, trade route, upwardly mobile, Vernor Vinge, Whole Earth Catalog, X Prize
Bass “If You Have Cancer, Don’t Go on the Internet”: Karl Sabbagh Incomprehensible Visitors from the Technological Future: Alison Gopnik “Go Native”: Howard Gardner The Maximization of Neoteny: Jaron Lanier Wisdom of the Crowd: Keith Devlin Weirdness of the Crowd: Robert Sapolsky The Synchronization of Minds: Jamshed Bharucha My Judgment Enhancer: Geoffrey Miller Speed Plus Mobs: Alan Alda Repetition, Availability, and Truth: Daniel Haun The Armed Truce: Irene M. Pepperberg More Efficient, but to What End?: Emanuel Derman I Have Outsourced My Memory: Charles Seife The New Balance: More Processing, Less Memorization: Fiery Cushman The Enemy of Insight?: Anthony Aguirre The Joy of Just-Enoughness: Judith Rich Harris The Rise of Internet Prosthetic Brains and Soliton Personhood: Clifford Pickover Immortality: Juan Enriquez A Third Replicator: Susan Blackmore Bells and Smoke: Christine Finn Dare, Care, and Share: Tor Nørretranders Getting Close: Stuart Pimm A Miracle and a Curse: Ed Regis “The Plural of Anecdote Is Not Data”: Lisa Randall Collective Action and the Global Commons: Giulio Boccaletti Informed, Tightfisted, and Synthetic: Laurence C.
Most likely the latter, because judicious use of the off button allowed a return to normalcy. Which brings me to the armed truce—an attempt to appreciate the positives and accept the negatives, to set personal boundaries and refuse to let them be breached. Of course, maybe it is just this dogmatic approach that prevents the Internet from changing the way I think. More Efficient, but to What End? Emanuel Derman Professor of financial engineering, Columbia University; principal, Prisma Capital Partners; former head, Quantitative Strategies Group, Equities Division, Goldman Sachs and Co.; author, My Life as a Quant: Reflections on Physics and Finance An engineer, a physicist, and a computer scientist go for a drive. Near the crest of a hill, the engine sputters and stops running. “It must be the carburetor,” says the engineer, opening his toolbox.
Trend Following: How Great Traders Make Millions in Up or Down Markets by Michael W. Covel
Albert Einstein, asset allocation, Atul Gawande, backtesting, Bernie Madoff, Black Swan, buy low sell high, capital asset pricing model, Clayton Christensen, commodity trading advisor, correlation coefficient, Daniel Kahneman / Amos Tversky, delayed gratification, deliberate practice, diversification, diversified portfolio, Elliott wave, Emanuel Derman, Eugene Fama: efficient market hypothesis, fiat currency, fixed income, game design, hindsight bias, housing crisis, index fund, Isaac Newton, John Nash: game theory, linear programming, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, market fundamentalism, market microstructure, mental accounting, Nash equilibrium, new economy, Nick Leeson, Ponzi scheme, prediction markets, random walk, Renaissance Technologies, Richard Feynman, Richard Feynman, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, South Sea Bubble, Stephen Hawking, systematic trading, the scientific method, Thomas L Friedman, too big to fail, transaction costs, upwardly mobile, value at risk, Vanguard fund, volatility arbitrage, William of Occam
.” • Trend followers are generally on the right side of big moves. • The most interesting aspect of the Barings Bank blowout was who won. Everyone knew the Queen’s bank lost, but the winners were trend followers in the zero-sum game. 179 The success of options valuation is the story of a simple, asymptotically correct idea, taken more seriously than it deserved, and then used extravagantly, with hubris, as a crutch to human thinking. Emanuel Derman76 It seems LTCM could have survived one Nobel prize-winner, but with two, they were doomed. Frederic Townsend77 180 Corporations make good and bad decisions every day offers one dealer. P&G made a bad decision. But if they came in with a Pampers line that flopped, you wouldn’t have hearings in Congress, would you?78 When the mind is in a state of uncertainty the smallest impulse directs it to either side.
Henry and Company, September 1998. 72. Barclay Trading Group, Ltd., Technical vs. Fundamental: How Do Traders Differ? Barclay Managed Futures Report, Vol. 2, No. 3 (2000). 73. Sir Arthur Conan Doyle, The Sign of Four. London and New York: Pitman and Sons, 1890. 74. Christopher L. Culp, Media Nomics (April 1995), 4. 75. The Coming Storm, The Economist (February 17, 2004), see www.economist.com/buttonwood. 76. Emanuel Derman, The Journal of Derivatives (Winter, 2000), 64. 77. Frederic Townsend, Futures (December 2000), 75. 78. Another Two Bites the Dust. Derivative Strategies (May 16, 1994), 7. Chapter 5 1. Michael J. Mauboussin and Kristen Bartholdson, The Babe Ruth Effect: Frequency versus Magnitude The Consilient Observer. Vol. 1, No. 2 (Credit Suisse First Boston, January 29, 2002). 2. Michael Lewis, Moneyball: The Art of Winning an Unfair Game.
Red-Blooded Risk: The Secret History of Wall Street by Aaron Brown, Eric Kim
Albert Einstein, algorithmic trading, Asian financial crisis, Atul Gawande, backtesting, Basel III, Benoit Mandelbrot, Bernie Madoff, Black Swan, capital asset pricing model, central bank independence, Checklist Manifesto, corporate governance, credit crunch, Credit Default Swap, disintermediation, distributed generation, diversification, diversified portfolio, Emanuel Derman, Eugene Fama: efficient market hypothesis, experimental subject, financial innovation, illegal immigration, implied volatility, index fund, Long Term Capital Management, loss aversion, margin call, market clearing, market fundamentalism, market microstructure, money: store of value / unit of account / medium of exchange, moral hazard, natural language processing, open economy, pre–internet, quantitative trading / quantitative ﬁnance, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, special drawing rights, statistical arbitrage, stochastic volatility, The Myth of the Rational Market, too big to fail, transaction costs, value at risk, yield curve
But Red Blood, Blue Blood, Cold Blood, Thin Blood, Hot Blood, Unblooded, and Blood Sucker are composites of real people I have worked with over the years. So I acknowledge here my debt to the dozens of people who provided slices of various characters’ history and attitudes. Many people read part or all of the manuscript and sent useful comments. Brandon Adams, Gustavo Bamberger, Bill Benter, John Bogle, Rick Bookstaber, Reuven Brenner, Eugene Christiansen, Emanuel Derman, Art Duquette, Dylan Evans, Doyne Farmer, Justin Fox, Kenneth French, Lisa Goldberg, James Grosjean, Ian Hacking, Michael Heneberry, Carey Hobbs, Craig Howe, James McManus, Michael Maubossin, Nick Maughan, Perry Mehrling, Robert Merton, Joe Nocera, John O’Brien, Deborah Pastor, Scott Patterson, William Poundstone, Kevin Rosema, Myron Scholes, James Stoner, Nassim Taleb, Edward Thorp, Whitney Tilson, James Ward, Paul Wilmott, and Bruce Zastera were particularly helpful.
Both cover quite a bit of history to ground their predictions in something solid. If you like to study your quantitative finance through people, Espen Haug’s Derivatives Models on Models is an excellent choice. Also consider The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It by Scott Patterson, My Life as a Quant: Reflections on Physics and Finance by Emanuel Derman, Inside the House of Money: Top Hedge Fund Traders on Profiting in the Global Markets by Steven Drobny, and More Money Than God: Hedge Funds and the Making of a New Elite by Sebastian Mallaby. The Economic Function of Futures Markets by Jeffrey Williams remains after 20 years the only really good account of this subject. If you want to know about trading, Michael W. Covel’s account of the famous so-called turtle experiment, in which more or less randomly chosen novices were trained to trade, is illuminating.
3D printing, agricultural Revolution, AI winter, Alan Turing: On Computable Numbers, with an Application to the Entscheidungsproblem, algorithmic trading, artificial general intelligence, augmented reality, autonomous vehicles, bitcoin, blockchain, clean water, cognitive dissonance, Colonization of Mars, complexity theory, computer age, computer vision, constrained optimization, corporate personhood, cosmological principle, cryptocurrency, cuban missile crisis, Danny Hillis, dark matter, discrete time, Elon Musk, Emanuel Derman, endowment effect, epigenetics, Ernest Rutherford, experimental economics, Flash crash, friendly AI, Google Glasses, hive mind, income inequality, information trail, Internet of things, invention of writing, iterative process, Jaron Lanier, job automation, John von Neumann, Kevin Kelly, knowledge worker, loose coupling, microbiome, Moneyball by Michael Lewis explains big data, natural language processing, Network effects, Norbert Wiener, pattern recognition, Peter Singer: altruism, phenotype, planetary scale, Ray Kurzweil, recommendation engine, Republic of Letters, RFID, Richard Thaler, Rory Sutherland, Search for Extraterrestrial Intelligence, self-driving car, sharing economy, Silicon Valley, Skype, smart contracts, speech recognition, statistical model, stem cell, Stephen Hawking, Steve Jobs, Steven Pinker, Stewart Brand, strong AI, Stuxnet, superintelligent machines, supervolcano, the scientific method, The Wisdom of Crowds, theory of mind, Thorstein Veblen, too big to fail, Turing machine, Turing test, Von Neumann architecture, Watson beat the top human players on Jeopardy!, Y2K
TOMASO POGGIO “Turing+” Questions PAMELA MCCORDUCK An Epochal Human Event MARCELO GLEISER Welcome to Your Transhuman Self SEAN CARROLL We Are All Machines That Think NICHOLAS G. CARR The Control Crisis JON KLEINBERG & SENDHIL MULLAINATHAN We Built Them, but We Don’t Understand Them JAAN TALLINN We Need to Do Our Homework GEORGE CHURCH What Do You Care What Other Machines Think? ARNOLD TREHUB Machines Cannot Think ROY BAUMEISTER No “I” and No Capacity for Malice KEITH DEVLIN Leveraging Human Intelligence EMANUEL DERMAN A Machine Is a “Matter” Thing FREEMAN DYSON I Could Be Wrong DAVID GELERNTER Why Can’t “Being” or “Happiness” Be Computed? LEO M. CHALUPA No Machine Thinks About the Eternal Questions DANIEL C. DENNETT The Singularity—an Urban Legend? W. TECUMSEH FITCH Nano-Intentionality IRENE PEPPERBERG A Beautiful (Visionary) Mind NICHOLAS HUMPHREY The Colossus Is a BFG ROLF DOBELLI Self-Aware AI?
When we deploy decision-making systems in matters of national defense, health care, and finance, as we do, the potential dangers of such confusion, both for individuals and for society, are particularly high. To guard against those dangers, it helps to be aware that we’re genetically programmed to act in trustful, intelligent-agency-ascribing ways in certain kinds of interactions, be they with people or machines. But sometimes a device that waddles and quacks is just a device. It ain’t no duck. A MACHINE IS A “MATTER” THING EMANUEL DERMAN Professor of financial engineering, Columbia University; senior adviser, KKR Prisma; author, Models.Behaving.Badly and My Life As a Quant A machine is a small part of the physical universe that has been arranged, after some thought by humans or animals, in such a way that when certain initial conditions are set up (by humans or animals) the deterministic laws of nature see to it that that small part of the physical universe automatically evolves in a way that humans or animals think is useful.
American Society of Civil Engineers: Report Card, Andrew Wiles, Bernie Madoff, Black Swan, call centre, correlation does not imply causation, cross-subsidies, Daniel Kahneman / Amos Tversky, edge city, Emanuel Derman, facts on the ground, Gary Taubes, John Snow's cholera map, moral hazard, p-value, pattern recognition, profit motive, Report Card for America’s Infrastructure, statistical model, the scientific method, traveling salesman
With most books focused on exciting new theories, the work of applied scientists has suffered from general neglect. Freakonomics is a notable exception, covering the applied research of the economics professor Steven Levitt. Two books in the finance area also fit the bill: in The Black Swan, Nassim Taleb harangues theoreticians of financial mathematics (and other related fields) on their failure in statistical thinking, while in My Life as a Quant, Emanuel Derman offers many valuable lessons for financial engineers, the most important of which is that modelers in the social sciences—unlike physicists—should not seek the truth. Daniel Kahneman summarized his Nobel-prize-winning research on the psychology of judgment, including the distinction between intuition and reasoning, in “Maps of Bounded Rationality: Psychology for Behavioral Economics,” published in American Economic Review.
Albert Einstein, Black-Scholes formula, Bretton Woods, Brownian motion, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, discovery of penicillin, discrete time, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, floating exchange rates, full employment, Henri Poincaré, implied volatility, index fund, Isaac Newton, John von Neumann, Joseph Schumpeter, Long Term Capital Management, Louis Bachelier, margin call, market clearing, martingale, means of production, moral hazard, naked short selling, price stability, principal–agent problem, quantitative trading / quantitative ﬁnance, RAND corporation, random walk, risk tolerance, risk/return, Ronald Reagan, shareholder value, Sharpe ratio, short selling, stochastic process, The Chicago School, the scientific method, too big to fail, transaction costs, tulip mania, Works Progress Administration, yield curve
While he had demonstrated that an options price depends on the underlying stock price mean and volatility, and the risk-free interest rate, the overall market for interest rates is much more multi-dimensional. The interest rate yield curve, which graphs rates against maturities, depends on many markets and instruments, each of which is subject to stochastic processes. His interest and collaboration with Emanuel Derman and Bill Toy resulted in a model of interest rates that was first used profitably by Goldman Sachs through the 1980s, but eventually entered the public domain when they published their work in the Financial Analysts Journal in 1990.2 Their model provided reasonable estimates for both the prices and volatilities of treasury bonds, and is still used today. Black was unusual among the Wall Street quants with whom he rubbed shoulders.
23andMe, Affordable Care Act / Obamacare, Albert Einstein, big data - Walmart - Pop Tarts, bioinformatics, business intelligence, call centre, cloud computing, computer age, conceptual framework, Credit Default Swap, crowdsourcing, Daniel Kahneman / Amos Tversky, Danny Hillis, data is the new oil, David Brooks, East Village, Edward Snowden, Emanuel Derman, Erik Brynjolfsson, everywhere but in the productivity statistics, Frederick Winslow Taylor, Google Glasses, impulse control, income inequality, indoor plumbing, industrial robot, informal economy, Internet of things, invention of writing, John von Neumann, Mark Zuckerberg, market bubble, meta analysis, meta-analysis, natural language processing, obamacare, pattern recognition, payday loans, personalized medicine, precision agriculture, pre–internet, Productivity paradox, RAND corporation, rising living standards, Robert Gordon, Second Machine Age, self-driving car, Silicon Valley, Silicon Valley startup, six sigma, skunkworks, speech recognition, statistical model, Steve Jobs, Steven Levy, The Design of Experiments, the scientific method, Thomas Kuhn: the structure of scientific revolutions, unbanked and underbanked, underbanked, Von Neumann architecture, Watson beat the top human players on Jeopardy!
“It’s the same as the science behind financial economics,” he says. That is not necessarily a confidence-inspiring statement, given the lessons of the 2008 financial crisis. Quants didn’t cause the crisis, but they played their part. Their risk models proved myopic because they were too simple-minded, unable to take account of the rich, chaotic tapestry of behavior, especially in times of stress. Emanuel Derman, a physicist and former quant at Goldman Sachs, explained the perils of math models in finance, in his 2011 book, Models Behaving Badly. After coming to Wall Street in 1985, Derman soon came to believe that physics models could be successfully applied to finance and economics—a belief he later abandoned. “In physics,” he writes, “you’re playing against God, and He doesn’t change His laws very often.
Swimming With Sharks: My Journey into the World of the Bankers by Joris Luyendijk
bank run, barriers to entry, Bonfire of the Vanities, bonus culture, collapse of Lehman Brothers, collective bargaining, credit crunch, Credit Default Swap, Emanuel Derman, financial deregulation, financial independence, Flash crash, glass ceiling, Gordon Gekko, high net worth, hiring and firing, inventory management, job-hopping, London Whale, Nick Leeson, offshore financial centre, regulatory arbitrage, shareholder value, sovereign wealth fund, the payments system, too big to fail
A number of interviewees were struggling with this very question on a daily basis, and our conversations inevitably turned to complexity, and to the profound changes brought to the world of finance over the past decades by ‘quants’. In the middle office, quants build or manage the models their bank uses to calculate and possibly neutralise (‘hedge’) its risks. Drawn from academic backgrounds in maths, physics, chemistry and biology, these wizards invented the products that played a key role in the crash. Renowned quant Emanuel Derman typifies this new breed. After a few years as a physicist in academia and AT&T Bell Laboratories, Derman went to work for Goldman Sachs in 1985. In his bestselling autobiography My Life As a Quant he writes: ‘In physics you’re playing against God. In finance, you’re playing against God’s creatures.’ The explosion of complexity across the financial sector is crucial to understanding the current state of the City, the interviewees said, so I was fortunate to find quants among the volunteers.
A Primer for the Mathematics of Financial Engineering by Dan Stefanica
asset allocation, Black-Scholes formula, capital asset pricing model, constrained optimization, delta neutral, discrete time, Emanuel Derman, implied volatility, law of one price, margin call, quantitative trading / quantitative ﬁnance, Sharpe ratio, short selling, time value of money, transaction costs, volatility smile, yield curve, zero-coupon bond
The strong commitment of the administration of Baruch College to support the MFE program and provide the best educational environment to our students was essential to all aspects of our success, and permeated to creating the opportunity for this book to be written. I learned a lot from working alongside my colleagues in the mathematics department and from many conversations with practitioners from the financial industry.. Special thanks are due to Elena Kosygina and Sherman Wong, as well as to my good friends Peter Carr and Salih Neftci. The title of the book was suggested by Emanuel Derman, and is more euphonious than any previously considered alternatives. Many students have looked over ever-changing versions of the book, and their help and encouragement were greatly appreciated. The knowledgeable comments and suggestions of Robert Spruill are reflected in the final version of the book, as are exercises suggested by Sudhanshu Pardasani. Andy Nguyen continued his tremendous support both on QuantNet.org, hosting the problems solutions, and on the fepress.org website.
My Life as a Quant: Reflections on Physics and Finance by Emanuel Derman
Berlin Wall, bioinformatics, Black-Scholes formula, Brownian motion, capital asset pricing model, Claude Shannon: information theory, Emanuel Derman, fixed income, Gödel, Escher, Bach, haute couture, hiring and firing, implied volatility, interest rate derivative, Jeff Bezos, John von Neumann, law of one price, linked data, Long Term Capital Management, moral hazard, Murray Gell-Mann, pre–internet, publish or perish, quantitative trading / quantitative ﬁnance, Richard Feynman, Sharpe ratio, statistical arbitrage, statistical model, Stephen Hawking, Steve Jobs, stochastic volatility, technology bubble, transaction costs, value at risk, volatility smile, Y2K, yield curve, zero-coupon bond
Written by perhaps the leading practitioner of his generation, this insightful narrative explores the disparate cultures of physics, finance, and their powerful fusion known as phynance. This book is a mustread for aspiring quants, financial historians, and armchair sociologists interested in the machinations of both academia and industry." -Peter Carr, Head of Quantitative Research, Bloomberg, and Director, Masters in Math Finance, NYU Emanuel Derman To the Memory of My Parents Ambition is a state of permanent dissatisfaction with the present. PROLOGUE THE TWO CULTURES 1 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 17 The attractions of science The glory days of particle physics ■ Driven by ambitious dreams to Columbia Legendary physicists and budding uwnderkinder Talent versus character, plans versus luck CHAPTER 2 DOG YEARS 29 ■ Life as a graduate student Wonderful lectures ■ T.
23andMe, Albert Einstein, Alfred Russel Wallace, banking crisis, Barry Marshall: ulcers, Benoit Mandelbrot, Berlin Wall, biofilm, Black Swan, butterfly effect, Cass Sunstein, cloud computing, congestion charging, correlation does not imply causation, Daniel Kahneman / Amos Tversky, dark matter, data acquisition, David Brooks, delayed gratification, Emanuel Derman, epigenetics, Exxon Valdez, Flash crash, Flynn Effect, hive mind, impulse control, information retrieval, Isaac Newton, Jaron Lanier, John von Neumann, Kevin Kelly, mandelbrot fractal, market design, Mars Rover, Marshall McLuhan, microbiome, Murray Gell-Mann, Nicholas Carr, open economy, place-making, placebo effect, pre–internet, QWERTY keyboard, random walk, randomized controlled trial, rent control, Richard Feynman, Richard Feynman, Richard Feynman: Challenger O-ring, Richard Thaler, Schrödinger's Cat, security theater, Silicon Valley, stem cell, Steve Jobs, Steven Pinker, Stewart Brand, the scientific method, Thorstein Veblen, Turing complete, Turing machine, Walter Mischel, Whole Earth Catalog
Charles Seife Randomness Without an understanding of randomness, we are stuck in a perfectly predictable universe that simply doesn’t exist outside our heads. Clifford Pickover The Kaleidoscopic Discovery Engine We are reluctant to believe that great discoveries are part of a discovery kaleidoscope and are mirrored in numerous individuals at once. Rebecca Newberger Goldstein Inference to the Best Explanation Not all explanations are created equal. Emanuel Derman Pragmamorphism Being pragmamorphic sounds equivalent to taking a scientific attitude toward the world, but it easily evolves into dull scientism. Nicholas Carr Cognitive Load When our cognitive load exceeds the capacity of our working memory, our intellectual abilities take a hit. Hans Ulrich Obrist To Curate In our phase of globalization . . . there is a danger of homogenization but at the same time a countermovement, the retreat into one’s own culture.
Frequently Asked Questions in Quantitative Finance by Paul Wilmott
Albert Einstein, asset allocation, Black-Scholes formula, Brownian motion, butterfly effect, capital asset pricing model, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discrete time, diversified portfolio, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, iterative process, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, martingale, Norbert Wiener, quantitative trading / quantitative ﬁnance, random walk, regulatory arbitrage, risk/return, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, stochastic volatility, transaction costs, urban planning, value at risk, volatility arbitrage, volatility smile, Wiener process, yield curve, zero-coupon bond
The resulting volatility structure never matches actual volatility, and even if exotics are priced consistently it is not clear how to best hedge exotics with vanillas so as to minimize any model error. Such concerns seem to carry little weight, since the method is so ubiquitous. As so often happens in finance, once a technique becomes popular it is hard to go against the majority. There is job safety in numbers. See Emanuel Derman and Iraj Kani (1994), Bruno Dupire (1994) and Mark Rubinstein (1994). 1996 Avellaneda and Parás Marco Avellaneda and Antonio Parás were, together with Arnon Levy and Terry Lyons, the creators of the uncertain volatility model for option pricing. It was a great breakthrough for the rigorous, scientific side of finance theory, but the best was yet to come. This model, and many that succeeded it, was non linear.
Albert Einstein, asset allocation, Atul Gawande, Bernie Madoff, business process, Cass Sunstein, choice architecture, clean water, Daniel Kahneman / Amos Tversky, David Brooks, delayed gratification, deliberate practice, disintermediation, Donald Trump, Douglas Hofstadter, Emanuel Derman, en.wikipedia.org, fear of failure, financial deregulation, financial independence, Flynn Effect, George Akerlof, Henri Poincaré, hiring and firing, impulse control, invisible hand, Joseph Schumpeter, labor-force participation, loss aversion, medical residency, meta analysis, meta-analysis, Monroe Doctrine, Richard Thaler, risk tolerance, Robert Shiller, Robert Shiller, school vouchers, six sigma, Steve Jobs, Steven Pinker, the scientific method, The Spirit Level, The Wealth of Nations by Adam Smith, Thorstein Veblen, transaction costs, Walter Mischel, young professional
Physicists and other hard scientists were achieving great things, and social scientists sought to match their rigor and prestige. The influential economist Irving Fisher wrote his doctoral dissertation under the supervision of a physicist, and later helped build a machine with levers and pumps to illustrate how an economy works. Paul Samuelson applied the mathematical principles of thermodynamics to economics. On the finance side, Emanuel Derman was a physicist who became a financier and played a central role in developing the models for derivatives. While valuable tools for understanding economic behavior, mathematical models were also like lenses that filtered out certain aspects of human nature. They depended on the notion that people are basically regular and predictable. They assume, as George A. Akerlof and Robert Shiller have written, “that variations in individual feelings, impressions and passions do not matter in the aggregate and that economic events are driven by inscrutable technical factors or erratic government action.”
No One Would Listen: A True Financial Thriller by Harry Markopolos
backtesting, barriers to entry, Bernie Madoff, call centre, centralized clearinghouse, correlation coefficient, diversified portfolio, Emanuel Derman, Eugene Fama: efficient market hypothesis, family office, fixed income, forensic accounting, high net worth, index card, Long Term Capital Management, Louis Bachelier, offshore financial centre, Ponzi scheme, price mechanism, quantitative trading / quantitative ﬁnance, regulatory arbitrage, Renaissance Technologies, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, statistical arbitrage, too big to fail, transaction costs
At Citigroup, thanks to Charlie Miles and Holly Robinson for your astute observations. To Leon Gross, thanks for your expert analysis; I wish the SEC had bothered to call you—things might have been different if they had. All of you were helpful at various points during my team’s investigation, proving that plenty of honest people work on Wall Street. I would like to thank the following people at Goldman Sachs for teaching me all about derivatives math: Dr. Joanne Hill, Dr. Emanuel Derman, Rebecca Cheong, Michael Liou, Jack Lehman, Mark Zurack, and Amy Goodfriend. To the late John “Front Page” Wilke of the Wall Street Journal for your courage and inspiration on all those corruption cases you broke. Real investigative journalists are a rare breed, but you were one of the best. I miss you. To Gregory Zuckerman of the Wall Street Journal and Ross Kerber of the Boston Globe, thank you for reporting the story when it first became public.
algorithmic trading, Berlin Wall, bonus culture, BRICs, business process, collapse of Lehman Brothers, collateralized debt obligation, complexity theory, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, disintermediation, diversification, Emanuel Derman, financial innovation, fixed income, friendly fire, Goldman Sachs: Vampire Squid, high net worth, housing crisis, London Whale, Long Term Capital Management, merger arbitrage, new economy, passive investing, performance metric, risk tolerance, Ronald Reagan, Saturday Night Live, shareholder value, short selling, sovereign wealth fund, The Nature of the Firm, too big to fail, value at risk
Interviews confirmed the level of dissonance at Goldman, even as a publicly traded firm, in discussing and understanding that the output of the models was and is unique to Goldman, which meant the firm was not as dependent on the models as were other firms, and that, combined with what sociologists call a “heterarchical structure” (less hierarchy in the chain of command than in many firms) and the trading experience of its top executives, gave Goldman an edge.8 The more intense scrutiny of the models and risk factors led Goldman’s top executives to pick up on market signals that other firms’ executives missed.9 As Emanuel Derman, the former head of the quantitative risk strategies group at Goldman and now a professor at Columbia, wrote, at Goldman, “Even if you insist on representing risk with a single number, VaR isn’t the best one … As a result, though we [Goldman] used VaR, we didn’t make it our religion.”10 (Meanwhile, at other firms, measures like “VaR [value at risk] … became institutionalized,” as the New York Times’ Joe Nocera put it.
Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen
algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Black-Scholes formula, Brownian motion, buy low sell high, capital asset pricing model, commodity trading advisor, conceptual framework, corporate governance, credit crunch, Credit Default Swap, currency peg, David Ricardo: comparative advantage, declining real wages, discounted cash flows, diversification, diversified portfolio, Emanuel Derman, equity premium, Eugene Fama: efficient market hypothesis, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, Gordon Gekko, implied volatility, index arbitrage, index fund, interest rate swap, late capitalism, law of one price, Long Term Capital Management, margin call, market clearing, market design, market friction, merger arbitrage, mortgage debt, New Journalism, paper trading, passive investing, price discovery process, price stability, purchasing power parity, quantitative easing, quantitative trading / quantitative ﬁnance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, systematic trading, technology bubble, time value of money, total factor productivity, transaction costs, value at risk, Vanguard fund, yield curve, zero-coupon bond
For instance, we consider a stock’s price-to-earnings ratio, not its enterprise value-to-earnings ratio because the latter would look bad for a leveraged firm just because the interest payments reduce the earnings. Hence, with enterprise value in the numerator, the denominator should have earnings before interest expenses. ___________________ 1 Quantitative traders are close cousins to, but perform different roles than, the “sell-side quants” described in Emanuel Derman’s interesting autobiography My Life as a Quant (2004). Sell-side quants provide analytical tools that are helpful for hedging, risk management, discretionary traders, clients, and other purposes. In contrast, quantitative traders work on the “buy-side” and build models that are used directly as a tool for systematic trading. 2 See Damodaran (2012) for an extensive description of equity valuation and financial statement analysis. 3 To see this result, first note that Then change index on the first book value and make the appropriate adjustments to arrive at which gives the residual income model.
Chaos Monkeys: Obscene Fortune and Random Failure in Silicon Valley by Antonio Garcia Martinez
Airbnb, airport security, Amazon Web Services, Burning Man, Celtic Tiger, centralized clearinghouse, cognitive dissonance, collective bargaining, corporate governance, Credit Default Swap, crowdsourcing, death of newspapers, El Camino Real, Elon Musk, Emanuel Derman, financial independence, global supply chain, Goldman Sachs: Vampire Squid, hive mind, income inequality, interest rate swap, intermodal, Jeff Bezos, Malcom McLean invented shipping containers, Mark Zuckerberg, Maui Hawaii, means of production, Menlo Park, minimum viable product, move fast and break things, Network effects, Paul Graham, performance metric, Peter Thiel, Ponzi scheme, pre–internet, Ralph Waldo Emerson, random walk, Sand Hill Road, Scientific racism, second-price auction, self-driving car, Silicon Valley, Silicon Valley startup, Skype, Snapchat, social graph, social web, Socratic dialogue, Steve Jobs, telemarketer, urban renewal, Y Combinator, éminence grise
* “Quant” is short for some flavor of quantitative analyst or quantitative trader. These are the financial engineers who recycle the mathematics of fluid mechanics or probability for the world of filthy lucre. They absolutely litter Wall Street now, and some areas of finance, like the hyperfast world of high-frequency trading, couldn’t exist without them. The most authentic view of their world was penned by a founder of the Goldman Strategies team, Emanuel Derman, in his classic My Life as a Quant. † For fans of schadenfreude, life is a never-ending feast. When the Madoff scandal, the largest Ponzi scheme in American history, erupted in late 2008, it would turn out that the Elie Wiesel Foundation for Humanity had invested all of its assets with Madoff. Elie’s son, Elisha, my boss, was the foundation’s treasurer. This reminds me of the joke about mixed emotions being the sight of your mother-in-law driving over a cliff in your new Porsche.
Antifragile: Things That Gain From Disorder by Nassim Nicholas Taleb
Air France Flight 447, Andrei Shleifer, banking crisis, Benoit Mandelbrot, Berlin Wall, Black Swan, credit crunch, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, discrete time, double entry bookkeeping, Emanuel Derman, epigenetics, financial independence, Flash crash, Gary Taubes, Gini coefficient, Henri Poincaré, high net worth, Ignaz Semmelweis: hand washing, informal economy, invention of the wheel, invisible hand, Isaac Newton, James Hargreaves, Jane Jacobs, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, knowledge economy, Lao Tzu, Long Term Capital Management, loss aversion, Louis Pasteur, mandelbrot fractal, meta analysis, meta-analysis, microbiome, moral hazard, mouse model, Norbert Wiener, pattern recognition, placebo effect, Ponzi scheme, principal–agent problem, purchasing power parity, quantitative trading / quantitative ﬁnance, Ralph Nader, random walk, Ray Kurzweil, rent control, Republic of Letters, Ronald Reagan, Rory Sutherland, Silicon Valley, six sigma, spinning jenny, statistical model, Steve Jobs, Steven Pinker, Stewart Brand, stochastic process, stochastic volatility, The Great Moderation, The Wealth of Nations by Adam Smith, Thomas Malthus, too big to fail, transaction costs, urban planning, Yogi Berra, Zipf's Law
I had exceptional and enthusiastic contributions from Will Murphy, Evan Camfield, Alexis Kirshbaum, Cynthia Taleb, Will Goodlad, Stefan McGrath, and Asim Samiuddin, who witnessed the progress of the book and contributed to its development. Generous comments and help: Peter Nielsen, Rory Sutherland, Saifedean Ammous, Max Brockman, John Brockman, Marcos Carreira, Nathan Myhrvold, Aaron Brown, Terry Burnham, Peter Boettke, Russ Roberts, Kevin Horgan, Farid Karkaby, Michael Schrague, Dan Goldstein, Marie-Christine Riachi, Ed Frankel, Mika Kasuga, Eric Weinstein, Emanuel Derman, Alberto Mingardi, Constantine Sandis, Guy Deutscher, Bruno Dupire, George Martin, Joelle Weiss, Rohan Silva, Janan Ganesh, Dan Ariely, Gur Huberman, Cameron Williams, Jacques Merab, Lorenzo Savorelli, Andres Velasco, Eleni Panagiotarakou, Conrad Young, Melik Keylan, Seth Roberts, John McDonald, Yaneer Bar-Yam, David Shaywitz, Nouriel Roubini, Philippe Asseily, Ghassan Bejjani, Alexis Grégoire Saint-Marie, Charles Tapiero, Barry Blecherman, Art De Vany, Guy Riviere, Bernard Oppetit, Brendon Yarkin, and Mark Spitznagel; and my online helpers Jean-Louis Reault, Ben Lambert, Marko Costa, Satiyaki Den, Kenneth Lamont, Vergil Den, Karen Brennan, Ban Kanj, Lea McKay, Ricardo Medina, Marco Alves, Pierre Madani, Greg Linster, Oliver Mayor, Satyaki Roy, Daniel Hogendoorn, Phillip Crenshaw, Walter Marsh, John Aziz, Graeme Blake, Greg Linster, Sujit Kapadia, Alvaro De La Paz, Apoorv Bajpai, Louis Shickle, Ben Brady, Alfonso Payno de las Cuevas, “Guru Anaerobic,” Alexander Boland, David Boxenhorn, Dru Stevenson, and Michal Kolano.
The Concepts and Practice of Mathematical Finance by Mark S. Joshi
Black-Scholes formula, Brownian motion, correlation coefficient, Credit Default Swap, delta neutral, discrete time, Emanuel Derman, implied volatility, incomplete markets, interest rate derivative, interest rate swap, London Interbank Offered Rate, martingale, millennium bug, quantitative trading / quantitative ﬁnance, short selling, stochastic process, stochastic volatility, the market place, time value of money, transaction costs, value at risk, volatility smile, yield curve, zero-coupon bond
When pricing an exotic option we should be careful to examine what features of the model it is particularly sensitive to. 18.8 Further reading Jim Gatheral's book, , is the best reference currently available on the dynamics of the volatility surface. Cont and Fonseca, , carried out a principal components analysis of the volatility surface for index options in S&P and FTSE. They have many interesting results including that relative movements of implied volatilities have little correlation with the underlying. Emanuel Derman carried out an analysis of how changes in spot related to changes in skew for the S&P 500 and identified differing regimes over time, . Other papers applying the same methodologies in different contexts are  and . See also ,  and  for further discussion of how option price movements are affected by spot movements in the real world. Eric Reiner examined many of the different possible smile dynamics in .