Phynance = Physics + Finance

Historically, students with advanced degrees in physics (i.e. a PhD) have rarely had the financial world in their sights. This changed in the last two decades of the 20th century when physicists began to get involved in the finance industry. The end product of this exercise was the emergence of financial engineers who use mathematical tools to model money. These professionals are called quants for short.

This post is a review of the book My Life as a Quant by Emanuel Derman. Derman came to the US from South Africa, obtained a PhD in particle physics from Columbia, rose to upper levels at Goldman Sachs, and now teaches financial engineering at Columbia. He worked closely with Black (of Black-Scholes equation fame) and has an interest rate model (the Black-Derman-Toy model) named after him.

The book is a quite detailed and revealing account of how physicists (can) transition into finance. As someone who knows practically nothing about the finance industry, I found it fascinating.

Early Years

Derman does not say too much about his initial years in South Africa; the book really gains meat once he lands in the US. It provides a substantial description of American physics graduate schools in the 70's (they haven't changed too much, perhaps).

Derman describes the almost religious devotion to fundamental physics with which he joined the PhD program at Columbia, the star faculty at the time in the department (Rabi was still around, but the emergent personality was T. D. Lee, both were Nobelists), his brilliant classmates, the loneliness that seems to be the lot of (especially) international students who are introverts, the long haul of coursework, the dog years of finding an advisor and solving a research problem whose impact on the field is not quite earth-shaking, the seven years (which he estimates as ten percent of his life span) taken to finally complete the PhD.

He describes three postdoctoral positions he then holds, at UPenn, Oxford and Rockefeller, marked by the not unusual travails of living separately from his wife, his mother's gradual lapse into Lou-Gehrig's disease, the lack of close friends, the pressure of generating results much faster than during the PhD, the low salary, the competition from highly gifted and driven physicists, the conflicts with postdoctoral advisors, and uncertainty about future employment. Finally, he finds a physics faculty position in Boulder, which he quits after one year, disliking the intense solitude the work forces upon him (interactions with faculty were sparse; those with students are not mentioned; his wife and now son were still living in New York).

The narrative until now repeats Derman's profound dissatisfaction with the academic process, loneliness and uncertainty, and the deepening realization that he will never do anything great (at the level of Einstein, Feynman, or T. D. Lee). During these years, Derman flirts with various Western philosophies, eastern (Buddhist) practices, and the idea of becoming a doctor.

Middle Years

After quitting academia Derman moves to Bell Labs. Here he discovers his love of computing (C and Unix had been invented at Bell recently) and his distaste for big bureaucracy. Almost from the beginning of his 5 years there, he looks for an exit strategy.

At this time, Wall Street is headhunting for software types since they need someone to model stocks and (more so) bonds, etc. Derman joins the Financial Strategies Group and is mentored by Ravi Dattatreya, himself an engineer who had quit Bell earlier. Here Derman flourishes. Good physicists are versatile, capable and interested in learning new things; the mathematics required to model securities is familiar to physicists as stochastic calculus; also physicists are used to writing their own code. All these qualities helped Derman excel at GS.

Quants, like physicists, read papers and build models. The most famous financial model is named the Black-Scholes-Merton (Scholes and Merton got the economics Nobel in 1997; Black had died earlier) equation. Fischer Black worked at GS and Derman soon got to collaborate with him; the book has many professional and personal recollections about Black, including how Derman was rehired by Black after a brief hiatus working at Salomon Brothers.

Later Years

In 2002 Derman retires from GS and starts teaching financial engineering at Columbia. This part of the book has interesting discussions about how his background in physics helped him flourish in finance. The kind of physics he was trained on is called phenomenology: here you don't come up with fundamentally new laws or even an exact microscopic description using known laws, for a system you are trying to understand. You just build a model which replicates the phenomena displayed by the system. This approach works nicely for modeling a complicated financial system, where the microscopic variables are not well characterized, and can take random values.

Summary

There is a lot of technical detail in the book about the details of the financial instruments Derman worked to model, the technology used by the industry (one of his first tasks was to build a GUI for traders), etc. As I am not an expert on these, I have largely left them out of the review.

For me, the interesting parts were how some physicists are not turned on by the agenda of academic physics which can feel like slaving away in a corner by yourself (I kind of enjoy that, actually); and also how the training of a physicist can be useful for tasks that one might not initially expect.

All in all a good read, giving us a window into an important physics-related development in the finance industry.