36: How A Quant Saw Huge Changes That Took Place on Wall Street

going to become like Joe's book Club? It's basically going to become Yeah, basically it's gonna be just here's what Joe read the week before and wants to talk more about. You know, but I, well, I can live. Yeah, it

won't be that bad. I read good stuff. But uh so, I recently had the chance to read the book My Life as a quant by Emmanuel Derman, who was a physic assist theoretical physicist who eventually joined Wall Street during the quantitative revolution and sort of was at all you know, all these sort of there's so much talk about the equations and models that run finance these days, and he was at the ground floor of how that all got

built up. Oh well, that's exciting. We've talked plenty about mathematical models and their role in finance on this podcast before, so exactly so, why not? Exactly so? Why not talked to one of the very original practitioners of it. And we have Emmanuel here in studio, So um, I say, let's get started. Let's do it. Emmanuel, thanks for joining us, my pleasure. I'm really glad to be here. So I

want to start with something in your book. One of the things that really struck me was you pointed out how the explosion of exotic equity derivatives was very much tied to the globalization of fine nand after the Cold War ended. And there's really seemed like a poignant thing to read right now after the Brexit vote, when it feels like the world is arguably deglobalizing a little bit. Finance seems to be in retreat. But explain to us the connection there, because I thought that that was something

that I had never thought of until I read your book. Yeah, that's very interesting. It's funny. Nobody's ever mentioned that to me about my book before I joined them. Equity derivatives at Goldman. I've been in fixed income. I joined Equit Derivatives in early and I was in charge of the quantitative Strategies group and we basically supported the options disc And there was this flowering of interest in exotic options

because and it was because of globalization. Essentially, once the Berlin Wall came down, people wanted to invest in foreign in foreign stock markets. They didn't want to buy individual stocks, so they used options, which was much simpler. There were indicas developed all over the world, from the neck to the keck to the decks, and everybody went to the part of it. And there was also this fashion in

finance forum. Well it's still going on for sort of not just buying your own country, not just buying the stock of your own company. Canadian actually, Canadian pension funds used to come to US because Canadian pension funds weren't allowed to buy more than a small amount of foreign stock, and so they would do their exposure through derivatives. Yes,

so explain that a little bit more. I think people understand what essentially an option is, but explain, well, why are they called exotic options and why do they have an important role in giving people this international exposure Okay, I'm glad you're asking that. No nobody have asked it before. The Well, an option is the right, but not the obligation,

to buy something for a certain price in the future. So, for example, you might have have the right to buy IBM a ar from today at a hundred dollars or whatever it is, and if IBM s trading above a hundred dollars at that point, you can buy it for a hundred dollars, sell it for a hundred and ten if it's trading on hundred and ten, and make ten bucks. And that's what people call vanilla standard call, And there's a put similarly, but with exotic options. They allowed you

to get a much more fine tuned exposure to different things. So, for example, the first thing I worked on, which was kind of famous, not not me individally, but a Goldman, was something called the Nike U the Nike put options, where Goldman issued puts on the Nike and the nick was trading at I don't remember it was that it's all time high of like twenty nine thousand or something like that. And there are a lot of people who were skeptical about the future of Japan. Rightly as it

turns out and Goldman sold puts on the Nike. But the reason they were exotic was people wanted a bet than the Nike going down, but they didn't want to face currency risk. And normally, if you bought to put on the Nike, the NICK might go down, but the end might strengthen, and so you wouldn't make any money even if the NICK went down. And what was exotic about these so called quanto options were that you locked in a guaranteed exchange rate. It didn't matter what the

yen dollar did. When you exercise your option, you got paid in dollars the amount that the unique dropped in percent. It was a put am I making sense. So that was exotic because so in other words, it's not just a planet, it's not a plane embedded in it. Are more scenarios and more hedges, yes, or actually less in a sense. You if you bought an ordery put on the Nick, you would be exposed to both the yen dollar and to the Nike, and this way you remove

the end dollar. So people would do this kind of stuff, or people would buy knockout options, which were very popular, which is an option that gives you money if it's called gives you money if the stock rises, but gets knocked out if the stock drops too low, if the stock drops too high. All of these ways were basically ways of making speculative bets. By putting up less money than you would for vanial option, you were betting on a smaller range of probabilities than just what was what

was reflected in an ordinary option. And Emmanuel, one thing I always wonder about when it comes to these sorts of exotic options and instruments is you're allowing me in investor to sort of fine tune their risk. But how do the banks that are actually offering these kind of products, how did they manage their risk? Because things like knockout options can be you know, um kind of painful for the issuer, right, yes, So I mean that that was

my job exactly. We we Golden for example, issued these exotic options, but if you sold them to somebody, you didn't want to suffer when they made money. So you had to head yourself. And you couldn't just buy an exotic option from one person and sell it to another, So you had to deconstructed and what black shoals and all the extensions of option pricing do is tell you essentially how to synthesize an option or an exotic option from the underlying which is the currency and the and

the nique itself. Am I making sense? I'm not sure? No? Absolutely, Okay. So so the models we worked on, which I did for ten years, told you how to dynamically every day trade the end dollar and every day trade the nika in order to replicate what you were selling to somebody else. You were selling them a package and now you had created for yourself so that when they wont you wouldn't lose. Yeah.

I love the way in your book you essentially described it as you're buying raw material, some combination of equity, cash, the end, and then you're repackaging it and basically selling it as a mark up like any other manufacturer done. Honestly, that's what it is. You're you're a middleman, you're a market maker, You're you're a wholesaler. You're buying complex stuff that people want to sell, and you're decomposing it into its constituents, or you're selling people complex stuff and making

it out of out of simple constituents. So it's really I think, I say in my book, it's a bit like fruit salad. If you want to know what you should charge for fruit salad, you have to know the cost of canning, the price of pears, apples, peaches, etcetera. And then you you had a spread for your risk. Because the models are really a little bit shaky. So

let's actually let's go back. Tell you you mentioned the black skulls method, but tell us about your beginning on Wall Street where quantitative finance was, and when you joined, and then what you worked on in your earlier years. You know, I came to Goldman, I've been a physicist before that, and then I worked for five years of the labs, where I already learned a lot of software engineering, which was very useful, and I joined Goldman in and the hot thing in those days interest rates were coming

down from the high of seventy nine. We've lived through a massive bull market in bonds right now. And I worked on black shoals explained how to price options on stock.

But now people were interested in buying options on bonds because as interest rates came down, people wanted to speculate on them going up again or going down again, and so there was a big market and options on treasury bonds, And the first thing I did was work with Fisher Black and a colleague of mine, Bill Toy, on trying to extend Black shoals into seeing yield curve things bonds

and bonds that paid coupons rather than stocks. And bonds are very different from stocks because stocks have no termination date, but bonds have a finite life, and and you really need a totally different model, And I worked on something called b d T everybody called it Black Dermon Toy, which was one of the early models I did. That. The world's gotten much more complicated since then. People make

much more elaborate models. So the way you describe the eighties and the sort of explosion in exotic options, it almost sounds like a sort of industrial revolution type thing for the financial industry. Suddenly you have this big evolution happening in products in ways to manage risk, and it kind of leads to, um, I guess, more revenue and growth of the financial industry as well. Yes, it was everybody. It was a globalization. Um, it was the ability to

trade farm markets suddenly. Um it was Actually I wasn't academic before. It was actually very excite. Everybody was waking up every day to new products coming out and trying to or your bank wanted to issue new products, and you were trying to figure out how to value them and hedge them because they want to eliminate as much

risk for themselves as possible. And so there was a there was a Yeah, there was a literal sort of efflorescence of papers on exotic options and how to hedge volatility and the invention I worked on variant swaps, which are ways of trading volatility rather than stocks. So how did you feel about actually leaving physics and academia and going to Wall Street because I imagine it must have been quite a different work environment, right, Yes, I was.

I was very ashamed. You know, people who in physics, and even I have colleagues today who are in physics, they go into I wrote about this in my book. They're going into physics a little bit like um with a religious sort of fervor, thinking they're getting to discover something fundamental, or try to discover something fundamental, and Um, everybody looks down on you if you start to become practical, if you start to go out to make a living. We all despised people who did that, and eventually I

did that too. Yeah. I think one of the little anecdotes in your book was about having some friend who who went to work on traffic patterns in the city and feeling sorry for him. Er. Yeah. Yeah. Even though it sounds like interesting stuff, it is. One of the lessons I've learned is that is that everything is interesting. It's sort of like to see the world in a grain of sand. If you look hard enough, then a

lot of things become interesting. But physics felt a bit like a religion, and people look down on you when you sort of left the monastery, and I felt that for a while. I spent five years at Bell Labs, which was interesting, but but it was my first experience of working in a corporation and I sort of hated it. And then when I came to gold to Wall Street into Goldman, I actually loved it because they kind of took an academic interest in this stuff, and so you

woke up every morning working on something interesting. But at the same time there were people who really wanted it. Yeah. Actually, I am one thing I still didn't quite understand. So while you were working for Goldman, you also published papers regularly and sort of publicized your findings how does that work? The tension of wanting to have a model that allows Goldman to profit while also wanting to do research that the public can know about and you can have your

name attached to. Yeah, that's that's some I think that's pretty much vanished. People on Wall Street, especially with Sabain's Oxley passing ten or fifteen years ago, they they don't publish much research anymore. But I grew up in an era where people developed new things and unless somebody really insisted that they were incredibly proprietary, like now, for example, algorithmic trading, people people won't published papers on. But the

options business was by and large a sales business. You know, you were making money not so much from speculating in volatility, but from providing people services and and the more you educated your clients, the better they understood what you were trying to do. So it was a bit of a struggle, but I worked for Fisher Black and I pushed quite hard. We had a culture where where unless somebody it's sort out,

where you could never publish. And then it became for a few years like they had to say you can't publish, rather than you can publish. Did you ever get pushed back from your employers, Goldman or someone else about I guess the real world application of some of the stuff you're doing, or its ability to generate money. Like if you were working on a project and they couldn't exactly see the commercial interest in it, would they ask you

to stop? Yeah, I mean, you know, I published a lot of papers and I like doing that, and I had a big group of people that did that, and and sometimes actually contact me, and they said they didn't realize what a rare environment it was, because most people

weren't allowed to do that. But we did that. But at the same time, our real job was building risk management systems for the people that traded equity derivatives, and so I would say we sort of earned our keep by building software that embedded these models and that let them manage that positions. And at the same time we had to build new models, and they moral less agreed to let us publish, so they sometimes didn't like it.

One of the things that I found that maybe everybody knew this before me, but that I did not know until I read it in your book, was that the seven stock market crash caused a permanent change to the financial market landscape in terms of how options before that crashed price in afterwards, and that had permanently changed the way people value things. Can you explain what happened? Yes, I can, um, and I'll make you writing a textbook. I've just finished the textbook on that right now. But

but what happened in before seven? People pretty much used the Black Sholes model to price options. Is it too technical to talk about different strikes? Okay, with different strikes, and they still use the same model and the tribute to the same risk to the stock that lay underneath

the option. But after seven, when the market dropped in October, in one day, all of a sudden, all hell broke loose, and from then on everybody being a bit anthropomorphic, but everybody understood that markets tend to crash down and glide up, which is kind of what's been happening here too. You get a big move down, but you get slow moves up. And so if the world is more likely to move down dramatically but go up slowly, you ought to charge more money for a put which will make money when

the market drops. And everybody immediately did that, and it's been like that ever since. It amazes me that The idea that markets don't crash up and only crash down was something that wasn't reflected in the market until seven. I mean we had market we had stock market crashes before then. Yeah, I guess there was no options market in in nine. And the options market didn't really get big until Black Black Controls published their paper in seventy three.

And yeah, there was a fourteen year period where where people didn't worry too much about the stuff. And it's been like that ever since. And in fact, the gold market changed in the late nineties because central central banks in some central in Switzerland did something other about gold, and ever since then, gold tends to crash up when

the market goes down. Gold doesn't God, Gold tends to go down slowly and go up dramatically, and so you get an inverse sort of option behavior that's been there since. So all this talk about market crashes is kind of reminding me of what's going on right now. In the aftermath of the Brexit referendum in the UK. Um we obviously saw market sell off after that, but we saw a lot of people worrying about what systematic traders, uh, you know, like risk parity guys that sort of thing

what they would do. And those guys have been likened before to sort of modern portfolio insurers in the sense that they could create this sort of feedback loop during a big sell off. I'd love to get your thoughts on that. I think that's true. I think anybody who behaves mechanically um um is behaving a bit like portfolio insurance, and and if people know it's coming, they start to

try to dodge it. I mean, there's pretty people have actually done very well in the best few months because they like them they invest equally in in bonds, stocks and commodities, and all of those things have gone up so um. But yes, since they're behaving mechanically, there is a danger that they keep doing the same thing. And and you can only be clever if you're a small

part of the of the ocean. But if you're the whole ocean, then then and everybody doing the same thing, then your models don't work because you're actually affecting affecting the thing you're trying to model. So yeah, I think that could happen. Uh. You mentioned that part of the reason you did the work earlier. Early on in your work, there was a lot of demand for it because there was a major shift in the direction of interest rates. Right now, interest rates are only going in one direction.

Every day we wake up to new lower rates around the world. Presumably one day that will change. It could be next week, it could be years from now. When that does happen, will we see once again lots of models just being completely destroyed and types of portfolio is not working and a sort of really really looking at how to do all this stuff. That's I mean, I

think that's already happening. That's a perceptive question. If you look at the thing I mentioned earlier, this Black Derman toy model, and essentially all the interest rate models that people built, they always assumed rates could never go negative. If you try buying software, they actually won't let you

enter a negative rate. And so I don't really work on this stuff anymore, but I think a lot of people have been working for banks on how do you value options when when there's actually a negative interest rate which the previous model just didn't allow. And I mean, this stuff is very different from physics. I try to point out in my book because in physics, once you figure out the way the planets work, they say that way they don't really care what you say about them.

But when you figure out a model for markets and everybody uses it, as Tracy was pointing out, it actually starts to affect the thing you're modeling, and so no model asks forever, you know, there's there's some It lives for a while, and then people get smarter when market which is what happened, and he said, when the market suddenly misbehaves and they adjust their model, and it's it's

sort of an endless leap frog in a way. Well, I suppose that gets to the heart of one of the major criticisms leveled at quantitative finance and at models, which is that how useful are they really? We hear all the time about like ten sigma events in markets, things that are only supposed to happen every you know, one day in five million years, and things like that, and they seem to keep happening. So clearly the models are missing something, right, Yeah, you're right, I think. Yeah,

I've written a lot about the section. I think models are only good as as long as the world stays in the sort of regime that you're currently in, and then they provide a good way of valuing things as long as things change a little bit, not too much. When you move to a new regime like negative interest rates or this old central bank um sort of the last seven years of risk on risk off, then your

old models don't work. And yeah, A kind of like to say, it's idolatry to imagine that you can write down an equation that's going to accurately reflect the way people behave. Uh So let's sort of start or go back to where we talked about in the beginning, with the connection of globalization and exotic options. In the wake of the Brexit vote, arguably finite the world maybe deglobalizing somewhat. What is uh, what is your assessment of the financial

industry these days? Every day we wake up to news about layoffs, retrenchments, large banks divesting their their foreign subsidiaries. Where do you see the industry going? You know, it goes in cycles. When I when I started out, it was very important to be able to program and to do quantitative work. Then at some point being able to program became a commodity that you could give to the I T people and you just did theoretical work, which I never really liked. And now now exotic options are

sort of pretty much a small market. Nobody's interested in that anymore. Everything's done electronically and algorithmically, and so software skills for for financial companies and investment banks and for hedge funds have become much more important. And so I'm looking for the point of the job market students now. Students now have to be good programmers if they want to get a job, which didn't used to be the

case ten or fifteen years ago. So I think everything is moving away from exoticism and towards vanilla products um algorithmic trading, high frequency trading by computer. That's what it's been like for the last five or six years, and I don't see that ending soon. Does that make you happy or sad? The idea that some of the exoticism of Wall Street might be going away now A little bit sad in the sense that I had a good time.

What was nice about the years that I worked at Goldman was that Goldman functioned in a very informal and bureaucratic way, at least for the first and for the first ten years I was there, And if you worked with the trading desk, it was a bit like being in physics. There were a bunch of traders who are like the experimentalists, and a bunch of quantity with the theorists, and you all spoke every day and you work together,

and it was kind of exciting. And I think what's said a little bit for me now is that most of the jobs for people are in bureaucracy and risk management and risk reporting, in basle regulations. And yeah, very very um very driven by regulation and reporting rather than actually trying to do new things. Is the regulation, while it may be boring and not exciting, is it at a good thing for society or do you think it could be a counterproductive I think it's good up to

a point. But I'm a bit of a skeptic about I'm a bit of a skeptic about what's happened in the last ideas I think they should have. I think that I think that the way people learn a good lesson is when they go bankrupt, when they lost a lot of money by being stupid, or by being careless, or but just just by the fact that that's the way the world works. And I think nothing's nothing prevents people from doing bad things again except getting punished by

the market for having done them. And I think forty page of regulation are are not an adequate substitute for just letting people go under when they do badly? Easy to say, I know, but but nevertheless, Uh so you mentioned that you're working on a textbook. Let's what is that? And also just what else are you interested in these days? Um,

I'm working. I taught a course on the volatility smile on this thing that happens in seven for the last ten or fifteen years, mostly based on the work I did at Goldman, and so I've just finished a textbook on that, which is coming out in September, and it has a very pretty cover from I don't know even know who hockey side was. He was some Spanish woodcutter a picture of a big wave which looks like a

volatility smile. So I'm finished that. Um. I wrote another book called Models Behaving Badly, which was more philosophical about the difference between models and physics. And I kind of like, I don't know, I've I've spent a lot of time doing quantitative stuff. I prefer doing qualitative stuff and writing. Now. Um there's actually I'm working a little bit with the

guy who's a professor of anthropology. This is kind of interesting at at at the News School, and there are a whole bunch of them who are very interested in the anthropology of finance and the way traders behave. And it's kind of interesting because traders use models that they know are wrong, but nevertheless they keep using them in a more or less effective way. And we're interested in sort of looking at at at how this works. And plus he's got this idea, which I think is right.

It's a little that that that volatility became an interesting thing in society in the last fifteen in the last thirty years. If you look at them, if you look at people writing surfboards are doing skateboarding, they're actually doing something very similar. When they go up and down, up and down, they're sort of hedging out there there. Maybe

I'm getting to complicate this is okay. Well, when you value an option, you first hedge it, and so you get rid of the pure market risk and what you left with is a sort of convexity kind of shape that's just the residual part of the option. And it's very similar in a in a metaphorical way to what skateboarders or to what surfers do when they ride they ride a wave, and they're not interested in the horizontal motion. They're interested in moving up and down the curve of

the wave as it as it curls. And um, this friend of mine is sort of interested in the whole idea of people in the world since the early seventies being interested in volatility as a as a as a quantity, the same way as people use options to trade volatility as an asset. So you know, people who wander through city streets and try to experience the excitement rather than trying to go somewhere. Is a is a sort of version of of optionality. Interesting. Well, it sounds like fascinating stuff,

and I hope you are now. I really want to read more about this stuff, and I hope you write on it. Okay, Um, yeah, my textbook is going to be a technical book, although I'm very against if I can say one more thing, Um, finance and financial engineering has gotten very mathematical in the last fifteen or twenty years, and I kind of disapproved people teach it as though it's a branch of mathematics, but really it's a real world field and it shouldn't have theorems or axioms. It's

about the way the world behaves. And I'm I'm trying to write my textbook in that way too, and a little bit of a of a counter counterpoint to the way that people people often teach finance. And now it's a branch of pure math, as though you write down axioms and you you know, like euclid, and you work out the results, and the world doesn't really work that way. And as you point out, all models are wrong. It's

just yes, which which ones are less wrong? Yes? All right, Emmanuel German, author of My Life as a quant and models are behaving badly and a forthcoming textbook on the volatility smile. Thank you very much for joining us. Thanks someone's glad to be here. Well, Tracy, I I loved that discussion. I'm guessing you did too, me too, I I gradgically admit I I will join the Joe Wisenthal

book Club in future. It's you know, one thing. I mean, there's a lot to unpack, obviously, but this, this topic seems like such a great way of looking at so much Wall Street history from it being strictly a sort of like personal driven business too. Then the rise of the mathematics too, then the software driven. It seems like by examining this we really get this sort of pretty big scope of how things have changed over the last

several decades. Yeah, and I think one of the really interesting things that Emmanuel pointed out towards the end of the conversation was that even though we essentially just recorded a podcast that was sort of about physics and mathematical models and quantitative finance, so oh, much of it actually has to do with human behavior and how traders and investors and people on Wall Street choose to use those models.

And uh, you know, we've seen in the past that sometimes it goes horribly wrong, and sometimes they do have a lot of practical use. So I find that fascinating. And sometimes people's emotions just make them cause them to make horrible decisions, even though everything that intellectually or their models would say, uh, would have advised against it exactly.

And you know what, Joe, this was actually a really timely discussion to have, given the market fallout from Brexit and all the discussion we've seen once again about var shocks and things that aren't supposed to be happening mathematically happening once again, it was a really timely discussion. I liked it. Yeah, you've written so much about That's a recurring theme of your writing is how these things that are supposed to only happen once every million years seemed

to happen a few times a year these days. Yeah, exactly. And unfortunately the models aren't really well suited to taking that into account, so we'll see what happens. All right, Well, this has been another edition of the Odd Lots Podcast. I'm Joe Wisnthal. You can follow me on Twitter at the Stalwart, and I'm Tracy Alloway. I'm on Twitter at Tracy Alloway. And you should follow Emmanuel Derman on Twitter at Emmanuel Derma. All Right, thanks for listening. We'll see you here next week.