Thursday, December 09, 2004

Life as a Quant

I've been reading Emanuel Derman's memoir, My Life as a Quant: Reflections on Physics and Finance. Derman was trained in theoretical physics, but left for finance after multiple postdocs and a stop at Bell Labs. He had a long and distinguished career at Goldman-Sachs, where he worked closely with Fischer Black of Black-Scholes fame. One of his most famous papers is on the volatility "smile" or skew, which I discussed in previous posts.

An entire chapter of the book is devoted to volatility, and ends with Derman admitting that no one really knows the fundamental cause behind the smile. His work had to do with extracting "local" volatility from an implied vol surface that is itself extracted from option prices over a range of strikes and expirations. One tantalizing fact I learned from the book is that prior to the 1987 crash there was no vol smile in SP options. This strongly suggests to me that the smile is at least partially caused by crash-averse portfolio managers buying puts as insurance and selling calls to defray the cost of that insurance (or simply to enhance profits). Puts would then be overbought while calls are oversold. (I took advantage of this in 2004 by buying a lot of long-dated SP calls, which are now in the money.)

I recommend this book to anyone interested in theoretical physics, mathematical finance or derivatives. Derman has a very down to earth writing style, but is also very insightful. This book is particularly valuable to students and postdocs in physics who want an insider's view of what a career in finance might be like.

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