Bringing a Scientific Perspective to Wall Street
Emanuel Derman was a pioneer in the now-established field of financial engineering, which was influenced by his background in theoretical physics.
Published October 6, 2005
By Adelle Caravanos
Academy Contributor
Emanuel Derman, director of the Columbia University financial engineering program, and Head of Risk at Prisma Capital Partners, will speak at the Academy on October 19. The self-described “quant” will discuss his unusual career path, from theoretical physics to Wall Street, where he became known for co-developing the Black-Derman-Toy interest-rate model at Goldman Sachs. His book, My Life As a Quant: Reflections on Physics and Finance, became one of Business Week’s Top Ten Books of 2004.
The Academy spoke with Derman in advance of his lecture.
*some quotes were lightly edited for length and clarity*
First, please tell our readers what a quant is!
Well, “quant” is short for quantitative strategist or quantitative analyst. It’s somebody who uses mathematics, physics, statistics, computer science, or any combination of these things at a technical level to try to understand the behavior of stock prices, auction prices, bonds, commodities, and various kinds of derivatives from a mathematical point of view — from a predictive view to some extent.
Is it safe to assume that most of the major banks employ quants?
Yes. When interest rates went up astronomically around [the time of], and even after, the oil crisis of ’73, [the hiring of quants] started in the fixed income business. Fixed income has always been a much more quantitative business historically than the rest of the securities business and people have always thought that bonds and fixed income investments were fairly non-volatile, stable, and safe. Once interest rates went up to around 15 percent and gold prices went up like crazy, investment banks and companies had a whole different range of problems to deal with than before.
They’d always known stocks were volatile, but not that bonds were. So, they started hiring people out of non-financial parts of universities, non-business schools — computer scientists, mathematicians, physicists, Bell Labs — to tackle these problems, partly because they involved more mathematics than people were used to and partly because they involved more computer science than people were used to.
If you had a whole portfolio of things, you couldn’t do them efficiently on paper anymore. You couldn’t take account of the changes or take account of what they were worth, so people started building computer programs to do these things. And so, there was an in-road there for a lot of quantitative people.
I think it was good to get in [to quantitative strategy] early because you could make a contribution with much less skill and talent. After 20 years everything gets so complicated mathematically that it’s much harder to do anything. It’s not impossible; people do it. But it was very exciting in the early ’80s because there were virtually no textbooks. You couldn’t get a degree in the field. Everybody was self-taught. It was exciting.
When you started at Goldman, were you one of the first of their quants?
They had maybe 10 or 20 people there. I was early, but I wasn’t the first.
You talk in your book about the difference between the way traders and quants approach problems.
I think the differences are less extreme now because quantitative methods have become much more ubiquitous all over Wall Street, particularly in hedge funds. But, yes, traders were impulsive, sharp, and gregarious. They liked meeting with people, and if you worked on the trading floor everybody was yelling and screaming. It’s exciting, but for people coming from an academic background, it is hard to concentrate! It’s chaotic. You have to multi-task a lot, which is very disturbing if you grew up wanting to do just one thing, like getting a PhD and working for six years solidly on it.
You also make the distinction between working on the mathematical models and the actual science or technology of working on the interfaces for the people. Which did you enjoy more?
I liked both. When I was in physics, we were always trying to do research and it was hard, lonely work. You shut yourself in an office and tried to make progress and when you couldn’t get anything done, or when things weren’t working, you had nothing else to do — it was really depressing.
What was nice about working at Goldman was that there were useful things you could do, like software, that didn’t take the same mental effort. They took talent and they took skill, but you didn’t have to discover something new to do them. So it was very nice to spend a quarter of your time doing research and half doing software and another quarter dealing with people. It was a much more balanced life.
Do you think that things are changing as far as academicians looking down at people going into the business world, and business people looking down at academicians?
I do think it goes both ways. I certainly looked down on people dropping out of PhDs and going into business. It felt like you were leaving the monastery before you’d become a monk. Academics brought you up to look down on anybody who copped out. And then business people always used “academic” as sort of a dirty word — “academic” in the sense of “not applied.”
About the Author
Professor Emanuel Derman is director of Columbia University’s program in financial engineering and Head of Risk at Prisma Capital Partners, a fund of funds. My Life as A Quant: Reflections on Physics and Finance was one of Business Week’s top ten books of the year for 2004. Derman obtained a PhD in theoretical physics from Columbia University in 1973. Between 1973 and 1980 he did research in theoretical particle physics, and from 1980 to 1985 he worked at AT&T Bell Laboratories.
In 1985 Derman joined Goldman Sachs’ fixed income division where he was one of the co-developers of the Black-Derman-Toy interest-rate model. From 1990 to 2000 he led the Quantitative Strategies group in the Equities division, where they pioneered the study of local volatility models and the volatility smile. He was appointed a Managing Director of Goldman Sachs in 1997. In 2000 he became head of the firms Quantitative Risk Strategies group. He retired from Goldman, Sachs in 2002.
Derman was named the IAFE/Sungard Financial Engineer of the Year 2000, and was elected to the Risk Hall of Fame in 2002.
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