"...tells wonderful stories of trying to bring highermathematics to the Goldman Sachs equity-derivatives trading desk."(Grant's Interest Rate Observer, Dec. 17, 2004)
Not many Wall Street veterans could write: "Visiting clients inMadrid, I dropped into the Thyssen museum, where I stumbled acrossseveral [Arthur] Dove paintings . . . in The Hague, too, after aEuronext options conference, I saw early Mondrian paintings oflilies that were influenced by [Rudolf] Steiner".
There are few "gentlemen bankers" left these days. Nor is theremuch room in the great financial houses for anything that smacks ofthe amateur spirit. That is why Emanuel Derman's memoirs are socompelling. As a physicist with a PhD from Columbia University, NewYork, he was not exactly a natural born trader when he joinedGoldman Sachs in 1985. He had spent most of the preceding 20 yearsin education and research.
But Derman got in at the ground floor of financial engineering, orquantitative finance, and spent two decades exploring the almostinfinite potential (and complexity) of derivative products andsophisticated risk management. Now back in academia, Derman hasreflected on his experiences of the past 40 years.
He begins his story in 1966, when he arrived in New York city fromSouth Africa as a bewildered, rather lonely 20 year old. Derman'sfirst degree in physics was from Cape Town university, but he hadcome to Columbia determined to make his name. "I dreamed of beinganother Einstein," he confesses. "I wanted to spend my lifefocusing on the discovery of truths that would live forever."
It took several years for Derman to accept that this ambition wouldnot be realised. Pure physics had room at the top for only ahandful of people. He struggled for years in a series of insecurepost-doctoral positions. "In much the same way, by a process [that]option theorists call time decay," he writes, "financial stockoptions lose their potential as they approach their ownexpiration."
Derman's wry humour and sense of irony are apparent throughout thebook. "If you didn't mind wasting the best years of your youth," hesays, "graduate student life at Columbia was paradise." Thesequalities, allied to his many and varied literary and culturalreferences, reveal him as a multi-layered personality. In spite ofhis later eminence on The Street in the 1980s and 1990s, this is nocrude Big Swinging Dick.
And he is not lying about wasting his youth. In 1969, when so manyyoung people of his generation were heading off to hang out atWoodstock, Derman admits: "I spent the summer of 1969 at a particlephysics summer school at Brookhaven National Laboratories in Upton,Long Island."
Eventually Derman abandoned pure physics for the - to him - lessnoble pursuit of applied physics, spending five years at AT&T'sBell Laboratories in New Jersey. This chapter, entitled "In thePenal Colony" - a reference to a Kafka short story of the same name- is a tale of corporate woe. The business world, while better paidthan academia, seemed to offer even less satisfaction andexcitement.
Derman says he learnt almost nothing about business or finance atAT&T, but he did learn to program and generally master the newgeneration of computers that were beginning to appear in the early1980s. When the headhunter's call finally took him to GoldmanSachs's financial strategies group in December 1985, it came as animmense relief.
Derman was charged with developing the famous Black-Scholes optionpricing model so it could be applied to bonds, an urgent task inthe more volatile markets of the post oil shock world. FischerBlack, one of the original model's authors, worked at Goldman andbecame a mentor and inspiration to Derman. Black, he writes, "wasgenuinely in love with the idea of equilibrium." Derman waseventually to become co-author of the Black-Derman-Toy model, whichpriced bond options.
In total, Derman spent 16 years at Goldman, with one unhappy yearat Salomon Brothers sandwiched in between. The former academic wasnot immune to the usual Wall Street temptation of leveraging abetter deal at another firm. Nine months after September 11 2001,Derman left Goldman to return to Columbia, where he now leads theprogramme in financial engineering.
Derman was one of the heroes of risk management in the 1990s,constantly pushing at the boundaries of what was possible, comingup with ever more sophisticated and ingenious structures. And yet asober scepticism, learned the hard way all those years ago inuniversity libraries, underpins his world view.
He is sardonic about his work: "The capacity to wreak destructionwith your models provides the ultimate respectability," he says."Many of the Long Term Capital Management protagonists are back inbusiness."
Now teaching again full time, Derman has grown even more sceptical."A decade of speaking with traders and theorists has made me wonderwhat 'correct' means," he writes. "The more I look at the conflictbetween markets and theories, the more that limitations of modelsin the financial and human world become apparent to me."(Financial Times, November 18, 2004)
Indecisive, introspective, awkward, and sometimes morose,memoirist Emanuel Derman comes across like a character in a SaulBellow novel. He wallows in loneliness after leaving his home inSouth Africa to earn a PhD in theoretical physics at ColumbiaUniversity. Later, he obsesses over leaving pure physics to doapplied research at Bell Laboratories. Then he punishes himselfwith guilt when he abandons physics entirely to work on WallStreet. Although he succeeds as a math-savvy "quant" at Goldman,Sachs & Co. (GS), he continues to ponder whether markets canreally be understood. "We are still on a darkling plain," he writestoward the end of his new book. "If you are a theorist you mustnever forget that you are traveling through lawless roads where thelocal inhabitants don't respect your principles."
That sense of being an intruder in outlaw territory lends anintriguing mood to Derman's My Life As a Quant, a literateand entertaining memoir of his two-stage career in physics andthen financial engineering. Wall Street looks quite different froma nerd's-eye view: "Geeks were fair game," Derman reflects. Once, achief trader who passed between him and a fellow quant "winced,clutched his head with both hands as though in excruciating pain,and exclaimed, 'Aaarrggh-hhh! The force field! It's too intense!Let me out of the way!"'
As one of Wall Street's leading quants, Derman did throw off someintense gamma radiation. He worked at Goldman from 1985 until 2003except for one year at Salomon Brothers. At Goldman, he moved fromfixed income to equity derivatives to risk management, becoming amanaging director in 1997. He co-invented a tool for pricingoptions on Treasury bonds, working with Goldman colleagues Bill Toyand the late Fischer Black, who co-invented the Black-Scholesformula for valuing options on stocks. Derman received theindustry's "Financial Engineer of the Year" award in 2000. Now hedirects the financial-engineering program at ColumbiaUniversity.
Derman failed at what he really wanted, which was to become animportant physicist. He was merely very smart in a field dominatedby geniuses, so he kicked around from one low-paying research jobto another. "At age 16 or 17, I had wanted to be another Einstein,"he writes. "By 1976...I had reached the point where I merely enviedthe postdoc in the office next door because he had been invited togive a seminar in France." His move to Wall Street anacknowledgment of failure brought him financial rewards beyondthe dreams of academic physicists and a fair measure ofsatisfaction as well.
In the tradition of the idiosyncratic memoir, My Life As aQuant is a grab bag of the author's interests. It quotesSchopenhauer and Goethe while supplying not one but three diagramsof a muon neutrino colliding with a proton. There is a long sectionon the brilliant and punctilious Fischer Black; a glimpse ofphysicist Richard Feynman; and an embarrassing encounter withfinance giant Robert Merton, who sat next to the author on a longflight (Derman treated him rudely before realizing who hewas).
Derman's mood seems to vary from bemused on good days to sour onbad ones. The chapter on his postdoc travels is titled "A Sort ofLife"; his brief career at Bell Labs, "In the Penal Colony"; histenure at Salomon Brothers, "A Severed Head." Pre-IPO Goldman Sachscomes off as relatively gentle yet stimulating. He writes: "It wasthe only place I never secretly hoped would crash and burn."
At times, his awkwardness is so extreme that it's funny. Here's howhe failed to work up his nerve to ask a Columbia professor to behis adviser: "Every time I saw him I smiled; every time I smiled hebared his lips back at me with greater awkwardness." It got sopainful that he began to flee whenever he saw the profcoming.
The most challenging part of the book and for techies, probablythe best is Derman's detailed explanation of trading tools hedeveloped. The Black-Derman-Toy model, from 1986, allowed tradingdesks to come up with prices for Treasury bond options based onmath rather than guesswork. In 1993 he and Goldman colleague IrajKani invented an options-pricing method that improved on an aspectof Black-Scholes its incorrect assumption that the volatility ofoptions is unvarying. They deduced the "local" volatility of aconventional option at each possible stock price and at each momentup to expiration. That information could then be used to priceexotic options more accurately.
As it turned out, both inventions had limitations in practice, butDerman accepts that. The theoretical purist finds a measure ofcontentment in contributing to the imprecise world of finance "intuiting, inventing, or concocting approximate laws andpatterns." It ain't E=mc2, but as he recognizes, it maybe the best anyone can hope for. By Peter Coy (BusinessWeek, November 15, 2004)
"Sadly, there's not much to buy in the stock or bond market thisholiday season, but John Wiley & Sons has published the perfectgift. "My Life as a Quant," by Emanuel Derman (292 pages, $29.95)is, indeed, a perfect memoir, as Derman, a South African-bornphysicist turned financial engineer, is a perfectmemoirist."Grant's Interest Rate Observer