My Life as a Quant (43 page)

The right way to engage with a model is, like a fiction reader or a really great pretender, to temporarily suspend disbelief, and then push it as far as possible. The success of the theory of options valuation, the best model economics can offer, is the story of a Platonically simple theory, taken more seriously than it deserves and then used extravagantly, with hubris, as a crutch to human thinking. “If a fool would persist in his folly, he would become wise,” wrote Blake in
The Marriage of Heaven and Hell
. This is what quants have done with options theory.

A little hubris is good. But then, when you're done modeling, you must remind yourself that you're theorizing about I's, and that, though God's world can be divined by principles, humanity prefers to remain mysterious. Catastrophes strike when people allow theories to take on a life of their own and hubris evolves into idolatry. Somewhere between these two extremes, a little north of common sense but still south of idolatry, lies the wise use of conceptual models. It takes judgment to draw the line.

Meanwhile, fundamental physics and its visions of ten-dimensional strings seem to get steadily more arcane, and quantitative finance becomes progressively more refined and detailed. Being a scientist can sometimes be depressing. Surrounded by younger versions of yourself, you are constantly confronted by the mismatch between the dreams of youth and the facts of maturity.

I once read J.P.S. Uberoi's biography of Goethe,
1
one of the last people to make contributions to both art and science. Goethe's
Theory of Colours
is a unified examination of the interior and exterior characteristics of light and color, conducted with an awareness of the observer himself. According to Uberoi, scientists tend to regard Goethe as a poet who strayed beyond his proper place. His critics said he mistakenly thought of Nature as a work of art, being qualitative and personal where he should have been quantitative and impersonal. But Goethe was not so naive as to think that Nature is a work of art, wrote Uberoi. Rather, he believed that the
description
of our knowledge of Nature should be a work of art.

I like to think in Goethean terms of what we do in quantitative finance: We try to make as beautiful and truthful a description as we can of what we observe. We're involved in intuiting, inventing, or concocting approximate laws and patterns. We combine both art and science in creating understanding. We use our intuition, our scientific knowledge and our pedagogical skills to paint a picture of how to think qualitatively, and then, within limits, quantitatively, about the world of human affairs, and in so doing, we influence and are influenced by other people's thoughts. There's not much more one could ask for in this life without being wishful.

1
J.P.S. Uberoi,
The Other Mind of Europe
:
Goethe as a Scientist
, Oxford University Press, Delhi (1984).

Acknowledgments

I am most indebted to Pamela van Giessen, my editor at John Wiley & Sons, Inc., who, several years ago, let me persuade her that writing a book about what it's like to be a quant was a good idea. From then on she provided inspiration, enthusiasm, guidance, and advice, on the big picture as well as on details. I'm thankful for her interest and patience; it is very unlikely I would have seen this endeavor through to its end without her.

Jennifer MacDonald at Wiley also provided useful help, as did the people at PV&M Publishing Solutions, in particular Joanna Pomeranz, Matt Kushinka, and Gabriella Kadar.

The kind encouragement I received from family, friends, and, sometimes, from relative strangers who later became friends, played a truly large part in my completing this book. Writing is a lonely pleasure, and a small amount of other people's enthusiasm can have a disproportionately large and beneficial impact. I am pleased to thank Beverly Bell, Steve Blaha, Richard Cohen, Nancy Cohen, Joshua Derman, Shulamit Derman, Sonya Derman, Michael Goodkin, Marc Groz, Ruth Jowell, Mike Kamal, Robert Kiernan, Mark Koenigsberg, Bob Long, Helga Nagy, Nassim Taleb, and Don Weingarten. Their positive words had more effect on me than they may realize, and I'm grateful to them. I am especially thankful to Ray Bacon, who encouraged me and offered helpful comments on the manuscript.

Finally, above all, I am pleased to thank my wife Eva, who patiently and carefully read and commented on large parts of the manuscript, and give me thoughtful suggestions, good advice, and moral support throughout its writing.

About the Author

Emanuel Derman is a principal and Head of Risk at Prisma Capital Partners and a professor and Director of the Program in Financial Engineering at Columbia University. He was formerly a managing director at Goldman, Sachs & Co., which he joined in 1985 after an initial career in academic life and at AT&T Bell Laboratories. He is the co-creator of the widely used Black-Derman-Toy interest rate model and the Derman-Kani local volatility model. Among his many awards and honors, he was named the SunGard/IAFE Financial Engineer of the Year in 2000 and was appointed to the Risk Hall of Fame in 2002. He has a PhD in theoretical physics from Columbia University and is the author of numerous articles in elementary particle physics, computer science, and finance.

Index

A

A Programming Language (APL)

Academic jobs, scarcity

Academics, isolation

Achyuthuni, Rao

Adams, Scott

Adjustable Rate Mortgage (ARM)

Adler, Dennis

Adler, Margot

AI.
See
Artificial intelligence

Akers, Karen

Algorithmics (financial software company)

Allen, Paul

Allstate (company)

Amazon.com

American Express merger

American Finance Association

American Mathematical Society

American mortgage market, size

American Physical Society

American put value, closed-form solution (search for)

American Stock Exchange, options conference, Amex

Analytics (company)

Anderson, P.W.

Animorphic (company)

Anthroposophists

APL.
See
A Programming Language

Applied mathematics

Applied physics, employment

Arab oil embargo (1973)

Arb group.
See
Meriwether

Area 10.
See
Bell Laboratories

Area 90 (Network Systems).
See
Bell Laboratories

ARM.
See
Adjustable Rate Mortgage

Aron, J.

Art of Computer Programming, The
(Knuth)

Arthur D. Little and Co.

Artificial intelligence (AI), Goldman approach

Asian call option, purpose

Aspen Center for Physics

Asymetrix (company)

Atomic physics

AT&T.
See
Bell Laboratories

AT&T Technical Journal

At-the-money option

At-the-money put

Auguries of Innocence
(Blake)

AutoBond (Diller), creation

Average call option, purpose

Avery, Oswald

B

Baby Bells, divestiture from AT&T

Back-of-the-envelope methods

Backus, John

Backus Normal Form (BNF)

Baker, Howard

Bank of America, partnership.
See
D.E. Shaw & Co.

Bankers Trust

Bannister, Roger

Bardeen, John

Barfield, Owen

Barrier options

BDT.
See
Black-Derman-Toy

Bear Stearns

Bég, Mirza Abdul Baqi

Bell, Beverly

Bell Journal of Economics and Management Science

Bell Laboratories (AT&T)

Bell System Technical Journal

Bell Telephone Companies

Bellcore (company)

Bellow, Saul

Bergier, Alex

Berk, Jonathan

Berkeley University

Bernstein, Jeremy

Beta decay

Bettelheim, Bruno

Bezos, Jeff

BGM.
See
Brace-Gatarek-Musiela

Big Bang

Binomial model

Binomial trees.
See also
Implied binomial tree

Bio-informatics programs

BK.
See
Black-Karasinski

Black, Fischer

Black box computerized statistical arbitrage

Black-Derman-Toy (BDT) model

Black-Karasinski (BK) model

Black-Scholes calculator, usage

Black-Scholes distribution

Black-Scholes formalism

Black-Scholes formula

Black-Scholes implied volatilities

Black-Scholes model coding

Black-Scholes options pricing model

Black-Scholes single-volatility framework

Black-Scholes stock option model, modifications for bonds

Black-Scholes value

Black-Scholes-Merton

Blaha, Steve

Blake, William.
See also Songs of Innocence and Experience, Auguries of Innocence

Blavatsky, Madame

Bloomberg, Michael

Bloomberg (financial software company)

BNF.
See
Backus Normal Form

Bohr, Niels

Bond options

Bond Portfolio Analysis (BPA)

Bonds

Bookstaber, Rick

Borror, Jeff

Bosco

BPA.
See
Bond Portfolio Analysis

Brace-Gatarek-Musiela (BGM) model

Brattain, Walter H.

Brenner, Menachem

Bronx High School of Science

Brookhaven National Laboratories

Bubble chamber20

Buckwalter, Alan

Buddhism, living principles

Business Analysis Systems Center

C

C (programming language)

C++ (programming language)

C (program), generation

C programming (test)

CAC-30

California Institute of Technology (Caltech)

Call options.

Callable bonds

Cambodia, American invasion

Cambridge Tripos examination

Cape Town.
See
University of Cape Town

Capital Asset Pricing Model (CAPM)

CAPM.
See
Capital Asset Pricing Model

Casio, information-storing watch

C-ATS (company)

CDC IXIS (company)

Celestial Seasonings Tea Company

CERN.
See
European Center for Nuclear Research

Chang, Lay Nam

Chaos: Making a New Science
(Gleick)

Chargaff, Erwin

Charmed quark

Chase, Chevy

Chogyam Trungpa

Chomsky, Noam

Christ, Norman

CIR.
See
Cox-Ingersoll-Ross

Circumstance, force

Citibank

Civilization, discontents

Clarendon Labs

Clark, Wesley

CNN

Cobol, usage

Cobrinik, Zach

Cockney rhyming

Collective behavior

Columbia University