Computing Value: Physicists on Wall Street
Physicists are applying quantitative financial analysis to the world of finance to develop better models for assessing risk.
Published July 1, 2006
By Emanuel Derman
Academy Contributor
Wall Street has been home to small groups of ex-physicists for the past twenty years. Nicknamed “quants,” these erstwhile scientists have been applying their skills in quantitative financial analysis at investment banks such as Morgan Stanley and more recently at adventurous private investment organizations known as hedge funds. The mathematical techniques quants use aren’t that different from those they learned in physics, and the intellectual satisfactions are comparable.
If you’re fortunate, there are potential rewards of another kind. I was trained as a particle physicist, and around the time I moved into finance in 1985 I read an interview in Forbes magazine with Stanley Diller, who headed a quant group at Goldman Sachs. “What degree do you have?” asked the interviewer. “A PhD,” replied Stan, “but don’t tell the people I work for – they’ll knock a half-million off my pay!”
It’s All About Risk
Quantitative finance is an interdisciplinary mix of business knowledge, physics-inspired models, mathematical techniques, and programming, all aimed at the valuation of financial securities. The common characteristic of all securities is risk, and the central problem is the valuation of risky securities. Stock prices fluctuate with news and opinion. Bond prices vary with interest rates and credit spreads. Options on stocks, whose payoff is a nonlinear function of the future stock price, embody an even more complex risk, and how to value them was a longstanding puzzle.
There is no theory that determines absolute value in finance. Instead, successful theories move up one level at a time, as in chemistry. To find the value of a complex security (a molecule), you figure out how you can synthesize it out of simpler, easily available securities (atoms). In 1973 Fischer Black, Myron Scholes, and Robert Merton discovered the recipe for synthesizing a stock option out of its atomic components.
Their method provided a basis for valuing all types of risk, and led Wall Street to invent a hierarchy of increasingly complex securities tailored to the exact appetites of their clients for the risk embedded in stocks, interest rates, exchange rates, credit ratings, and other financial instruments. Since then, theory and practice have leapfrogged into ever more exotic terrain.
Deceptive Similarities
Although the language of financial theory closely resembles the language of mathematics and physics, the similarities can be deceptive. “Physics has three laws that explain 99% of the phenomena, but finance has 99 laws that explain about 3%,” quips Andrew Lo, a finance professor at MIT.
The major difficulty is that in physics you’re playing against God, and he doesn’t change his laws too often. In finance, you’re playing against people like yourself, subject to the ephemeral whims, moods, panics, and excitement that make human life so interesting.
You cannot hope to capture that kind of complexity in a formula. Financial models are more akin to what physicists call gedanken (thought) experiments than they are to fundamental theories. Any model is at best a small, self-consistent universe you can use as a laboratory to examine cause and effect. Actual markets are much messier, and so you always have to shoehorn the real world into one of your simple descriptions. That isn’t easy and it takes experience as much as technical skill.
Though great discoveries have been made, quantitative finance still awaits its Newton. The standard model in finance, for example, assumes that stock prices undergo Brownian motion, a phenomenon familiar to all physicists. But Brownian motion is a smooth evolution devoid of the crashes that plague markets and confound our theories. Quants-as-theorists and traders-as-experimentalists are working together on finding better models, and with luck, laws.
Also read: Bringing a Scientific Perspective to Wall Street
About the Author
Emanuel Derman, a theoretical physicist, is director of the financial engineering program at Columbia University, as well as a principal at Prisma Capital Partners. His book My Life as A Quant: Reflections on Physics and Finance (Wiley) was one of BusinessWeek’s top ten for 2004. He formerly ran the quantitative strategies group at Goldman Sachs.
