Friday, August 28, 2009

Derman, My Life as a Quant

Emanuel Derman’s My Life as a Quant: Reflections on Physics and Finance (Wiley, 2004) is one of the most engrossing books I’ve read in a long time. Derman, a South African who earned a Ph.D. in physics at Columbia and subsequently worked at Bell Labs (“the penal colony”), got his first Wall Street job with Goldman Sachs’s Financial Strategies Group at the end of 1985. After a brief interlude in the form of a “troubled year” at Salomon Brothers, he returned to head Goldman’s Quantitative Strategies Group, Equities Division, and eventually became head of Derivatives Analysis, Firmwide Risk as well as head of Quantitative Risk Strategies. In 2002 he said farewell to Goldman and left the Street for good.

For those non-quants who simply want a glimpse into Wall Street culture Derman’s book is tantalizing. For instance, in 1990 free food was available both for Goldman partners (“their daily lunch [was] brought to them on a large silver tray delivered by a gracious, white-coated food server, each plate covered by its own elegant warming dome”) and for employees on the Equities trading floor. “When you arrived in the morning, a gentleman dropped by to pick up your food order on which you could select anything you liked from a collection of local restaurant menus. The point was to keep you at your desk while the markets were open and clients were calling. Almost everyone ordered monumentally large helpings of lunch, drinks, and snacks.” (p. 207) But after the massive losses in the fixed income market in 1994, these food privileges were revoked. During the dot-com boom of 2000, employees were once again treated to free snacks, which promptly disappeared with the collapse of the technology IPO market. “You could see Wall Street’s behavior—its manic depressive, feast-or-famine style of hiring and firing, expanding and contracting, large raises followed by large cuts—all mirrored in the waxing and waning of the food supply.” (p. 208)

What intrigued me most about the book, however, was Derman’s account of his quant projects at Goldman. Two stand out in my mind. First, the so-called King of Denmark puts. And second, assessing firmwide derivatives risk.

An equity options trader at Goldman had acquired large numbers of inexpensive put options on the Nikkei as the index was soaring. He suggested that Goldman issue a listed put on the Nikkei for dollar-denominated accounts. The suggestion in itself was formulaic: “Buy some simple, less attractive product wholesale, use financial engineering to transform it into something more appealing, and then sell it retail.” (p. 210) What made these put warrants appealing was that they offered protection against a potential weakening of the yen against the dollar. They were guaranteed exchange-rate options. The problem for the quants was: how could Goldman hedge itself against an unfavorable move in the dollar-yen exchange rate that could eat into profits? Derman outlines their answer, which naturally lies outside the bounds of this brief review.

At the end of his career with Goldman, Derman’s primary mission as head of the Derivatives Analysis group was to make sure that the billions of dollars of exotic or illiquid derivatives were being appropriately marked to model. The problem was that “you know that the model you are using is both naïve and wrong—the only question is how naïve and how wrong.” (p. 259) Faced with uncertainty, Derman “assumed that the future could be one of several foreseeable worlds, and that there was consequently a range of possible values one could legitimately assign to the option.” The risk team compared the desk’s mark-to-model value with the range of many-worlds values. If the desk’s mark fell inside this range it was allowed. “Furthermore, since there is a range of plausible values, we recommended that Goldman hold in reserve an amount equal to the average mismatch between the range of plausible values and the desk’s actual mark.” (p. 260) Of course, I don’t know whether this was Goldman’s risk management policy when the credit markets imploded and whether, if it was, it served them well. I doubt that a financial meltdown was one of the foreseeable worlds.

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