ffirs_derman.qxd 7/21/04 4:21PM Pagei More Praise for My Life as a Quant “An honest account of the experience of going from an envi- ronment of Nobel Prize winners and pure thought to one of money,money,money.Derman gives us unique insight into the motivations of academia,the pressure to cast off worldly success in favor of matters more cerebral, then the mixed feelings during his descent into a world where the bottom line is P&L, and finally his success at bringing his own style of science into investment banking.” —Paul Wilmottt, mathematician,author,and fund manager “A fascinating personal account of one man’s journey through several of the leading institutions of our time.Written by per- haps the leading practitioner of his generation, this insightful narrative explores the disparate cultures of physics,finance,and their powerful fusion known as phynance.This book is a must- read for aspiring quants,financial historians,and armchair soci- ologists interested in the machinations of both academia and industry.” —Peter Carr, Head of Quantitative Research,Bloomberg, and Director,Masters in Math Finance,NYU ffirs_derman.qxd 7/21/04 4:21PM Pageii ffirs_derman.qxd7/21/044:21PMPageiii My Life as a Quant Reflections on Physics and Finance Emanuel Derman John Wiley & Sons, Inc. ffirs_derman.qxd 7/21/04 4:21PM Pageiv Copyright © 2004 by Emanuel Derman.All rights reserved. Published by John Wiley & Sons,Inc.,Hoboken,New Jersey Published simultaneously in Canada No part of this publication may be reproduced,stored in a retrieval system,or trans- mitted in any form or by any means,electronic,mechanical,photocopying,recording, scanning,or otherwise,except as permitted under Section 107 or 108 of the 1976 United States Copyright Act,without either the prior written permission of the Publisher,or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center,Inc.,222 Rosewood Drive,Danvers,MA 01923, 978-750-8400,fax 978-646-8600,or on the web at www.copyright.com.Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons,Inc.,111 River Street,Hoboken,NJ 07030,201-748-6011,fax 201-748-6008. 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Wiley also publishes its books in a variety of electronic formats.Some content that appears in print may not be available in electronic books. For more information about Wiley products,visit our Web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data Derman,Emanuel. My life as a quant : reflections on physics and finance / Emanuel Derman. p. cm. Includes biographical references and index. ISBN 0-471-39420-3 (cloth) 1. Derman,Emanuel 2. Investment advisors—Biography. 3. Physicists—Biography. 4. Options (Finance) 5. Quantum theory. 6. Mathematical physics. I. Title. HG4621.D47 2004 332.6′092—dc22 2004007664 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 ffirs_derman.qxd 7/21/04 4:21PM Pagev To the Memory of My Parents ffirs_derman.qxd 7/21/04 4:21PM Pagevi ffirs_derman.qxd 7/21/04 4:21PM Pagevii Ambition is a state of permanent dissatisfaction with the present. ffirs_derman.qxd7/21/044:21PMPageviii ftoc_derman.qxd 7/21/04 12:21PM Pageix Contents PROLOGUE THE TWO CULTURES 1 (cid:1) Physics and finance (cid:1) What quants do (cid:1) The Black-Scholes model (cid:1)Quants and traders (cid:1)Pure thought and beautiful mathe- matics can divine the laws of physics (cid:1)Can they do the same for finance? (cid:1) CHAPTER 1 ELECTIVE AFFINITIES 17 (cid:1)The attractions of science(cid:1)The glory days of particle physics (cid:1) Driven by ambitious dreams to Columbia (cid:1)Legendary physicists and budding wunderkinder (cid:1)Talent versus character,plans versus luck (cid:1) CHAPTER 2 DOG YEARS 29 (cid:1) Life as a graduate student (cid:1) Wonderful lectures (cid:1) T. D. Lee, the brightest star in the firmament (cid:1) Seven lean years (cid:1) Getting out of graduate school only half-alive (cid:1) CHAPTER 3 A SORT OF LIFE 53 (cid:1) The priesthood of itinerant postdocs (cid:1) Research isn’t easy (cid:1) Almost perishing,then publishing(cid:1)The delirious thrill of collab- oration and discovery (cid:1) CHAPTER 4 A SENTIMENTAL EDUCATION 65 (cid:1)Oxford’s civilized charms(cid:1)One physics paper leads to another (cid:1)English idiosyncrasies(cid:1)The anthroposophists (cid:1) ix ftoc_derman.qxd 7/21/04 12:21PM Pagex (cid:2) X (cid:2) CONTENTS CHAPTER 5 THE MANDARINS 77 (cid:1)Research and parenthood on New York’s Upper East Side (cid:1)A good life,but...the tensions of twin careers (cid:1) CHAPTER 6 KNOWLEDGE OF THE HIGHER WORLDS 85 (cid:1)A two-city family(cid:1) New age meditations(cid:1) Karma(cid:1) Goodbye to physics (cid:1) CHAPTER 7 IN THE PENAL COLONY 95 (cid:1) The world of industry—working for money rather than love (cid:1) The Business Analysis Systems Center at Bell Labs (cid:1) A small part of a giant hierarchy(cid:1)Creating software is beautiful (cid:1) CHAPTER 8 STOP-TIME 117 (cid:1) Wall Street beckons (cid:1) Interviewing at investment banks (cid:1) Leaving the Labs (cid:1) CHAPTER 9 TRANSFORMER 129 (cid:1) The Financial Strategies Group at Goldman, Sachs & Co. (cid:1) Learning options theory (cid:1)Becoming a quant (cid:1)Interacting with traders (cid:1)A new cast of characters (cid:1) CHAPTER 10 EASY TRAVEL TO OTHER PLANETS 143 (cid:1) The history of options theory (cid:1) Meeting and working with Fischer Black(cid:1)The Black-Derman-Toy model (cid:1) CHAPTER 11 FORCE OF CIRCUMSTANCE 175 (cid:1) Manners and mores on Wall Street (cid:1) The further adventures of some acquaintances(cid:1)Volatility is infectious (cid:1)