The King of Quants: A Conversation with Emanuel Derman, Part 3
In this, the third and final part of our conversation with
financial engineer and author of My Life as a Quant,
Emanuel
Derman, TradingMarkets CEO and co-founder Larry Connors discuss the
practical side of financial engineering, how to get started in the
field, what opportunities there are for mathematically inclined
analysts and traders and whether or not financial institutions were
greedy or just got it plain wrong when it came to the subprime
mortgage debacle.
For Part 2, click
here.
For Part 1,
here.
Larry Connors: I’ll give you a hypothetical: I’ve got a son
or daughter that’s 18 years old and decides he or she decides to
become a financial engineer. Give me the path for them for the next
ten years.
Emanuel Derman: Get a bachelor’s degree in solid subjects
like math, statistics, applied math, – physics, yes or no. I’m a
physicist but I don’t think that’s critical. But a lot of rigorous
things.
Financial modeling isn’t that rigorous and though many people may
not agree with me but I think it’s a mistake to start it too early.
That is, unless you want to become a trader when you’re 18 and know
that for sure.
But if you want to be a financial engineer I think you first need a
really firm basis in skills that are not ephemeral, you know? You’re
always going to need to know real analysis or computer programming or
statistics.
I’m not saying don’t do any financial engineering, but I’m a little
bit wary of jumping straight into the field.
Connors: Yes.
Derman: And then, in an ideal world, learn some finance and
then work for two years in the financial business. That will help you
decide whether you like the research side or the trading and sales
side of the business.
Then, if you want to be a financial engineer, come back and get a
master’s degree or a PhD in that field. And if you don’t, go back and
work on Wall Street or get an MBA or do something completely
different.
But there is more than one way to skin a cat. You can go straight
to a master’s in financial engineering. Most of our students in the
program actually come directly from undergraduate school, get a
masters and then go out into the world and get jobs.
Connors: What’s usually their first job? Do you see a
common theme as a first job when they come out?
Derman: Well, I’ll tell you. One common theme is that 90%
of them are foreign-born, foreign-educated.
Connors: Interesting.
Derman: Americans – I am too. But Native Americans don’t
want to go that way, though more of them do now that quantitative
people can take positions and actually trade and do statistical
arbitrage. It’s better than ten years ago. Because firms see that
there’s money to be made by using quantitative techniques.
Most of our students are foreign-born and most of them get jobs
afterwards – exactly what depends on their skills.
Some as traders. Some of them as quantitative people on a trading
desk helping the traders and building models. Some go into risk
management. Many move into hedge funds, increasingly. I think the
big difference in the last seven or eight years is that most people
used to go the sell side. And now many go to the buy side, to asset
management, and to hedge funds. That’s where the jobs are.
Connors: The last question that I have is this. Let’s look
ahead over the next two-three-four-five years. We’re building models
today, hypothetically.
Where are the biggest edges? I remember having a conversation with
a neighbor of mine – this was back on the West Coast – who was one of
the larger, better commodity traders in the world back in the
’80s.
When I asked him how he did it, he basically said he was in markets
that nobody else was in and was doing things that, really, nobody else
was looking at.
Where would you send someone today to find edges?
Derman: Well, just before I answer that, I sort of think
that’s true of life in general, especially if you’re a little bit
lazy. Whether you’re in physics or you’re in finance, the way to have
the biggest bang for your buck is to go into some area – whether
you’re in trading or in financial engineering – where nobody’s done
virtually anything.
I mean, BDT was a little bit like that. You know, there are many
more sophisticated approaches now, but you get a lot of impact if you
grasp the essence of the problem even if your mathematics isn’t that
sophisticated.
So it’s always good to be first through the door, you know? To be
the guy that does the first order thing and let other people add the
corrections is a nice piece of luck.
Connors: Would you say that possibly the international
markets may have these opportunities? Where would you look?
Derman: People were doing emerging markets a few years ago.
Japan in the early ’90s was a lucrative place to trade volatility
because people didn’t think in volatility terms.
Ten years ago the people who bought options in Europe during the
Internet boom didn’t really care about volatility. They cared about
getting a cheap way to leverage a bet on pharmaceutical or Internet
stocks.
On the other hand, the investment banks or the trading desks that
catered to them didn’t care about stock up or stock down, they cared
about volatility. And I’m making this a little bit more organized and
simplistic than it sounds, but desks could charge higher volatility to
people who didn’t care about volatility but cared about stock
direction.
If you can find places where people have different aims and
different metrics then you can make money between the cracks – It’s
sort of like lotteries in the sense that people will pay a small
amount of money for less-than-fair odds because they don’t really care
about the odds.
You can get more of that in places where there are new products,
and particularly high margin products. Desks make money by custom
tailoring – either by custom tailoring for people who want something
that they can’t acquire off-the-shelf.
Connors: So it sounds these types of edges, these
opportunities, will exist over the next “x” amount of years until
those markets become mature.
Derman: I think so, although it’s probably harder now
because everybody’s plunging in and markets go electronic very
quickly, where as before, they weren’t –
Connors: Yes.
Derman: And so I think those opportunities get harder.
I guess there two ways to make money: one is sort of an asset
management approach, where you take positions. The other way is the
service side, where you’re a wholesaler and you’re just trying to make
the spread, you know, or you make fancy stuff for people who can’t get
what they want in a world of simple listed securities.
As I was saying about bond options earlier. You know, you could
buy bond options 20 years ago on the Chicago Board of Options
Exchange, but they were generic. You couldn’t buy one written on the
particular bond that you owned. Am I making sense?
Connors: Yes, yes.
Derman: In other words, if you were Fidelity, you could sell
a call on some bond future, you know? And you could use that in a
complicated way to hedge or speculate. But that wasn’t the call you
wanted—