Authors: Emanuel Derman
More Praise for
My Life as a Quant
“An honest account of the experience of going from an environment of Nobel Prize winners and pure thought to one of money, money, money. Derman gives us unique insight into the motivations of academia, the pressure to cast off worldly success in favor of matters more cerebral, then the mixed feelings during his descent into a world where the bottom line is P&L, and finally his success at bringing his own style of science into investment banking.”
âPaul Wilmottt, mathematician, author, and fund manager
“A fascinating personal account of one man's journey through several of the leading institutions of our time. 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 must-read for aspiring quants, financial historians, and armchair sociologists interested in the machinations of both academia and industry.”
âPeter Carr, Head of Quantitative Research, Bloomberg, and Director, Masters in Math Finance, NYU
Copyright Â© 2004 by Emanuel Derman. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey
Published simultaneously in Canada
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Library of Congress Cataloging-in-Publication Data
My life as a quant : reflections on physics and finance / Emanuel Derman.
Includes biographical references and index.
ISBN 978-0-471-39420-4 (cloth)
ISBN 978-0-470-19273-3 (paper)
1. Derman, Emanuel 2. Investment advisorsâBiography. 3. PhysicistsâBiography. 4. Options (Finance) 5. Quantum theory. 6. Mathematical physics. I. Title.
To the Memory of My Parents
The Two Cultures
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?
If mathematics is the Queen of Sciences, as the great mathematician Karl Friedrich Gauss christened it in the nineteenth century, then physics is king. From the mid-seventeenth century to the end of the nineteenth, Newton's Law of Gravitation, his three Laws of Motion, and his differential calculus described with apparent perfection the mechanical motion of objects in our world and the solar system.
In 1864, two hundred years after Newton, the Scottish physicist James Clerk Maxwell formulated the compact and elegant differential equations that described with similarly astounding precision the propagation of light, X-rays, and radio waves. Maxwell's equations showed that electricity and magnetism, formerly separate phenomena, were part of the same unified electromagnetic field.
We cannot simply look at the world around us and deduce Newton's Laws or Maxwell's equations. Data on its own does not speak. These equations were triumphs of the mind, abstracted from the world in some miraculous confluence of hard thinking and deep intuition. Their success confirmed that pure thought and beautiful mathematics have the power to discover the most profound laws of the universe.
At the start of the twentieth century, the pace accelerated. Einstein, pondering the conflicts between the Newtonian and Maxwellian views of the world, proposed his Theory of Special Relativity that amended Newton's mechanics and made them consistent with Maxwell's equations. Fifteen years later Einstein trumped Newton again with his proposal of the General Theory; it corrected the Law of Gravitation and described gravity as a large-scale wave in space and time. At almost the same time, Bohr, SchrÃ¶dinger, and Heisenberg, with help from the ever-prodigious Einstein, developed the quantum mechanical theory of the small-scale behavior of molecules, atoms, and subatomic particles.
It was Einstein who perfected this mental approach to discovering the laws of the universe. His method wasn't based on observation or empiricism; he tried to perceive and then enunciate the very principles that constrained the way things should work. In a 1918 speech on the principles of research given in honor of Max Planck, the discoverer of the quantum, Einstein captured the magus-like appeal of trying to see through a glass, darkly, when he said: “There is no logical path to these laws; only intuition, resting on a sympathetic understanding of experience, can reach them.”
What is the purpose behind the search for scientific laws, in any field? Clearly, it's divinationâforetelling the future, and controlling it. Most of the modern technologies we enjoy, rely on, detest, or fearâcell phones, electric power grids, CAT scans, and nuclear weapons, for exampleâhave been developed by using the basic principles of quantum mechanics, electromagnetic theory, and relativity, all of which were discovered by cerebration. The classic tools of twentieth-century divination have indeed been those of physics. More recently, physicists have begun to employ the same tools in finance.
For the past twenty years, throughout Wall Street and the City of London, in most major and many minor financial institutions, small groups of ex-physicists and applied mathematicians have tried to apply their skills to securities markets. Formerly called “rocket scientists” by those who mistakenly thought that rocketry was the most advanced branch of science, they are now commonly called “quants.”
Quants and their cohorts practice “financial engineering”âan awkward neologism coined to describe the jumble of activities that would better be termed
. The subject is an interdisciplinary mix of physics-inspired models, mathematical techniques, and computer science, all aimed at the valuation of financial securities. 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.
Until recently, financial engineering wasn't really a subject at allâwhen I entered the field in 1985, it didn't have a name and was something one learned on the job at an investment bank. Now you can get a master's degree in the subject at scores of institutionsâthe Courant Institute at New York University, the University of Michigan at Ann Arbor, and the University of Oregon in Eugene, to name a few. Since July 2003 I have been a professor of the subject at Columbia University. Engineering schools, statistics and mathematics departments, and business schools organize these one- to two-year programs; they promise to transform students, in exchange for about $30,000 per year, into employable financial engineers. So popular are these degrees that some universities run several similar programs in distinct departments.
Nowadays, managers on Wall Street receive daily calls and emailed rÃ©sumÃ©s from PhDs seeking jobs in finance. Physics journals publish increasing numbers of papers on financial economics. And increasingly, physicists and mathematicians working on the quantitative side of banking have been joined by PhDs and faculty members from finance departments and business schools. Two of the best graduate finance departments in the country, the Sloan School at MIT and the Haas School of the University of California at Berkeley, have each lost several of their best young finance faculty to the banking and trading worlds.
Part of the reason for the influx of physicists to other fields was the 1970s collapse of their traditional job market: academia. Thirty years earlier during World War II, the invention of radar and the construction of the atomic bomb confirmed the usefulness of physics to postwar governments. Shocked by the successful voyage of Sputnik, the Departments of Defense and Energy began to fund pure research more copiously, and physicists seeking grants to do such research weren't above playing up the spin-off benefits of their work. Physics departments in the 1960s grew and academic posts multiplied. Inspired by the subject and supported by scholarships, a wave of ardent graduate students entered the field.
The good times didn't last. By the end of the Vietnam War a deteriorating economy and a public revulsion with science in the service of war put a large dent in research funds. During the 1970s and 1980s, many theoretical physicists who had once hoped to devote their lives to fundamental research were forced to become migratory laborers if they wanted to remain in academia, taking temporary short-term positions in universities and national laboratories wherever they became available. Many of us eventually gave up the struggle to find even a low-paying semipermanent academic job and turned to other areas. We sought physics-related jobs in a variety of fieldsâin energy research or telecommunications, for example. Former colleagues of mine began to work on alternate power sources at the Solar Energy Research Institute in Golden, Colorado, or on the mathematics of oil retrieval at Schlumberger in Ridgefield, Connecticut. Others helped develop advanced switching systems at AT&T's Bell Laboratories in New Jersey.