WEBVTT - 36: How A Quant Saw Huge Changes That Took Place on Wall Street 0:00:07.480 --> 0:00:11.480 Hello, and welcome to another episode of the Odd Lots Podcast. 0:00:11.600 --> 0:00:15.440 I'm Joe Wisenthal, Managing editor at Bloomberg Markets, and I'm 0:00:15.440 --> 0:00:19.239 Tracy Alloway, Executive editor at Bloomberg Markets. So, Tracy, you 0:00:19.280 --> 0:00:23.040 know what's something really fun about having a podcast? Okay, 0:00:23.120 --> 0:00:26.799 tell me what that I can read a book or 0:00:26.880 --> 0:00:30.840 read an article and then two days later say, hey, 0:00:30.880 --> 0:00:33.640 we should have the author of that in that article 0:00:33.800 --> 0:00:36.839 or book on to discuss that, and we can do that. 0:00:36.960 --> 0:00:38.800 I think that's a really cool thing. Is this podcast 0:00:38.840 --> 0:00:41.479 is going to become like Joe's book Club. It's basically 0:00:41.479 --> 0:00:44.519 going to become Yeah, basically it's going to be just 0:00:44.640 --> 0:00:46.600 here's what Joe read the week before and wants to 0:00:46.640 --> 0:00:50.280 talk more about. You know, but I, well, I can live. Yeah, 0:00:50.400 --> 0:00:52.000 it won't be that bad. I read good stuff. But 0:00:52.920 --> 0:00:55.360 uh so, I recently had the chance to read the 0:00:55.400 --> 0:00:59.200 book My Life as a quant by Emmanuel Derman, who 0:00:59.440 --> 0:01:04.000 was a physic assist theoretical physicist who eventually joined Wall 0:01:04.040 --> 0:01:08.680 Street during the quantitative revolution and sort of was at 0:01:08.720 --> 0:01:10.920 all you know, all these sort of there's so much 0:01:10.959 --> 0:01:15.200 talk about the equations and models that run finance these days, 0:01:15.880 --> 0:01:19.240 and he was at the ground floor of how that 0:01:19.400 --> 0:01:22.720 all got built up. Oh well, that's exciting. We've talked 0:01:22.800 --> 0:01:26.440 plenty about mathematical models and their role in finance on 0:01:26.480 --> 0:01:30.840 this podcast before, so exactly so, why not exactly so, 0:01:31.040 --> 0:01:34.720 why not talk to one of the very original practitioners 0:01:34.760 --> 0:01:38.760 of it. And we have Emmanuel here in studio. So um, 0:01:38.800 --> 0:01:41.720 I say, let's get started. Let's do it. Emmanuel, thanks 0:01:41.760 --> 0:01:44.360 for joining us, my pleasure. I'm really glad to be here. 0:01:44.840 --> 0:01:47.480 So I want to start with something in your book. 0:01:47.560 --> 0:01:50.080 One of the things that really struck me was you 0:01:50.160 --> 0:01:56.520 pointed out how the explosion of exotic equity derivatives was 0:01:56.720 --> 0:02:01.160 very much tied to the globalization of fine and after 0:02:01.200 --> 0:02:04.040 the Cold War ended. And there's really seemed like a 0:02:04.120 --> 0:02:08.120 poignant thing to read right now after the Brexit vote, 0:02:08.160 --> 0:02:13.040 when it feels like the world is arguably deglobalizing a 0:02:13.080 --> 0:02:16.960 little bit. Finance seems to be in retreat. But explain 0:02:17.080 --> 0:02:19.520 to us the connection there, because I thought that that 0:02:19.600 --> 0:02:22.560 was something that I had never thought of until I 0:02:22.600 --> 0:02:25.040 read your book. Yeah, that's very interesting. It's funny. Nobody's 0:02:25.040 --> 0:02:27.720 ever mentioned that to me about my book before I 0:02:27.840 --> 0:02:31.680 joined them. Equity derivatives at Goldman. I've been in fix income. 0:02:31.720 --> 0:02:34.560 I joined Equit Derivatives in early and I was in 0:02:34.639 --> 0:02:38.639 charge of the quantitative Strategies group and we basically supported 0:02:39.240 --> 0:02:43.160 the options disc And there was this flowering of interest 0:02:43.200 --> 0:02:47.239 in exotic options because and it was because of globalization essentially, 0:02:47.320 --> 0:02:50.560 once the Berlin Wall came down, people wanted to invest 0:02:50.600 --> 0:02:53.639 in foreign in foreign stock markets. They didn't want to 0:02:53.639 --> 0:02:57.280 buy individual stocks, so they used options, which was much simpler. 0:02:57.320 --> 0:02:59.639 There were indicas developed all over the world, from the 0:02:59.720 --> 0:03:03.120 NICK to the CAC to the decks, and everybody went 0:03:03.160 --> 0:03:04.880 to the part of it. And there was also this 0:03:05.000 --> 0:03:07.760 fashion in finance forum. Well it's still going on for 0:03:07.840 --> 0:03:09.880 sort of not just buying your own country, not just 0:03:09.919 --> 0:03:13.239 buying the stock of your own company. Canadian actually Canadian 0:03:13.440 --> 0:03:16.240 pension funds used to come to US because Canadian pension 0:03:16.240 --> 0:03:19.000 funds weren't allowed to buy more than a small amount 0:03:19.000 --> 0:03:21.040 of foreign stock, and so they would do their exposure 0:03:21.080 --> 0:03:24.079 through derivatives. Yes, so explain that a little bit more. 0:03:24.080 --> 0:03:28.960 I think people understand what essentially an option is, but explain, well, 0:03:29.000 --> 0:03:31.679 why are they called exotic options and why do they 0:03:31.720 --> 0:03:36.160 have an important role in giving people this international exposure Okay, 0:03:36.200 --> 0:03:38.960 I'm glad you're asking that. No nobody have asked it before. 0:03:39.080 --> 0:03:42.200 The Well, an option is the right, but not the obligation, 0:03:42.280 --> 0:03:44.600 to buy something for a certain price in the future. 0:03:44.640 --> 0:03:47.920 So for example, you might have have the right to 0:03:47.960 --> 0:03:50.440 buy IBM a U from today at a hundred dollars 0:03:50.520 --> 0:03:52.560 or whatever it is, and if IBM is training above 0:03:52.600 --> 0:03:54.760 a hundred dollars at that point, you can buy it 0:03:54.760 --> 0:03:56.320 for a hundred dollars, sell it for a hundred and 0:03:56.360 --> 0:03:57.920 ten if it's training a hundred and ten, and make 0:03:57.960 --> 0:04:01.240 ten bucks. And that's what people called vanilla standard call, 0:04:01.480 --> 0:04:05.000 and there's a put similarly, but with exotic options. They 0:04:05.040 --> 0:04:08.360 allowed you to get a much more fine tuned exposure 0:04:08.440 --> 0:04:11.160 to different things. So, for example, the first thing I 0:04:11.200 --> 0:04:14.160 worked on, which was kind of famous, not not me individally, 0:04:14.200 --> 0:04:17.600 but a Goldman, was something called the Nike Um the 0:04:17.680 --> 0:04:20.440 Nick put options, where Goldman issued put some the Nike 0:04:20.960 --> 0:04:23.120 and the Nick was trading at I don't remember what 0:04:23.160 --> 0:04:24.640 it was. That it's all time high of like twenty 0:04:24.720 --> 0:04:26.880 nine thousand or something like that. And there are a 0:04:26.880 --> 0:04:29.360 lot of people who were skeptical about the future of Japan. Rightly, 0:04:29.360 --> 0:04:33.240 as it turns out and Goldman sold puts on the Nike. 0:04:33.560 --> 0:04:36.560 But the reason they were exotic was people wanted a 0:04:36.560 --> 0:04:38.520 better the Nike going down, but they didn't want to 0:04:38.560 --> 0:04:40.839 face currency risk. And normally, if you bought to put 0:04:40.839 --> 0:04:43.320 on the Nike, the Nike might go down, but the 0:04:43.440 --> 0:04:45.599 end might strengthen, and so you wouldn't make any money 0:04:45.600 --> 0:04:48.239 even if the Nick went down. And what was exotic 0:04:48.279 --> 0:04:52.279 about these so called quanto options were that you locked 0:04:52.279 --> 0:04:54.520 in a guaranteed exchange rate. It didn't matter what the 0:04:54.600 --> 0:04:58.080 yen dollar did. When you exercise your option, you got 0:04:58.080 --> 0:05:01.760 paid in dollars the amount that the unique dropped in percent. 0:05:01.920 --> 0:05:04.159 It was a put am i making sense. So that 0:05:04.279 --> 0:05:07.480 was exotic because so in other words, it's not just 0:05:07.560 --> 0:05:10.839 a plane of the net, it's not a plane embedded 0:05:10.880 --> 0:05:15.279 in it. Are more scenarios and more hedges, yes, or 0:05:15.279 --> 0:05:17.400 actually less in a sense. You if you bought an 0:05:17.440 --> 0:05:19.760 ordery put on the Nick, you would be exposed to 0:05:19.800 --> 0:05:22.440 both the yen dollar and to the Nike, and this 0:05:22.520 --> 0:05:25.120 way you remove the end dollar. So people would do 0:05:25.160 --> 0:05:28.080 this kind of stuff, or people would buy knockout options, 0:05:28.080 --> 0:05:31.279 which were very popular, which is an option that gives 0:05:31.279 --> 0:05:33.240 you money if it's called gives you money if the 0:05:33.360 --> 0:05:37.200 stock rises, but gets knocked out if the stock drops 0:05:37.240 --> 0:05:38.919 too low, if the stock drops too high. All of 0:05:38.920 --> 0:05:43.919 these ways were basically ways of making speculative bets. By 0:05:44.000 --> 0:05:46.120 putting up less money than you would for vanial option, 0:05:46.200 --> 0:05:48.680 you were betting on a smaller range of probabilities than 0:05:48.760 --> 0:05:51.440 just what was what was reflected in an ordinary option. 0:05:52.000 --> 0:05:55.359 And Emmanuel, one thing I always wonder about when it 0:05:55.400 --> 0:05:59.120 comes to these sorts of exotic options and instruments is 0:05:59.200 --> 0:06:01.880 you're allowing me in vestor to sort of fine tune 0:06:01.920 --> 0:06:06.120 their risk. But how do the banks that are actually 0:06:06.480 --> 0:06:09.839 offering these kind of products, how did they manage their risk? 0:06:09.880 --> 0:06:14.279 Because things like knockout options can be you know, um 0:06:14.360 --> 0:06:18.599 kind of painful for the issuer, right, yes, So I 0:06:18.600 --> 0:06:21.680 mean that that was my job exactly. We we Golden 0:06:21.760 --> 0:06:25.400 for example, issued these exotic options, but if you sold 0:06:25.400 --> 0:06:27.840 them to somebody, you didn't want to suffer when they 0:06:27.880 --> 0:06:30.479 made money. So you had to head yourself. And you 0:06:30.480 --> 0:06:32.800 couldn't just buy an exotic option from one person and 0:06:32.839 --> 0:06:36.000 sell it to another, So you had to deconstructed and 0:06:36.720 --> 0:06:39.480 what black shoals and all the extensions of option pricing 0:06:39.520 --> 0:06:42.800 do is tell you essentially how to synthesize an option 0:06:43.000 --> 0:06:45.279 or an exotic option from the underlying which is the 0:06:45.320 --> 0:06:49.320 currency and the and the nique itself. Am I making sense? 0:06:50.600 --> 0:06:53.600 I'm not sure? No? Absolutely, Okay. So so the models 0:06:53.640 --> 0:06:56.039 we worked on, which I did for ten years, told 0:06:56.040 --> 0:06:59.840 you how to dynamically every day trade the end dollar 0:07:00.320 --> 0:07:04.560 and every day trade the nika in order to replicate 0:07:04.600 --> 0:07:06.679 what you were selling to somebody else. You were selling 0:07:06.720 --> 0:07:09.000 them a package and now you had created for yourself 0:07:09.000 --> 0:07:11.320 so that when they won, you wouldn't lose. Yeah. I 0:07:11.360 --> 0:07:14.440 love the way in your book essentially described it as 0:07:15.400 --> 0:07:21.200 you're buying raw material, some combination of equity, cash the end, 0:07:21.640 --> 0:07:24.760 and then you're repackaging it and basically selling it as 0:07:24.800 --> 0:07:28.840 a mark up like any other manufacturer done. Honestly, that's 0:07:28.840 --> 0:07:31.760 what it is. You're you're a middleman, you're a market maker, 0:07:31.880 --> 0:07:35.680 You're you're a wholesaler. You're buying complex stuff that people 0:07:35.800 --> 0:07:39.280 want to sell, and you're decomposing it into its constituents, 0:07:39.400 --> 0:07:42.800 or you're selling people complex stuff and making it out 0:07:42.800 --> 0:07:45.400 of out of simple constituents. So it's really I think, 0:07:45.400 --> 0:07:47.160 I say in my book it's a bit like fruit salad. 0:07:47.200 --> 0:07:49.040 If you want to know what you should charge for 0:07:49.080 --> 0:07:51.160 fruit salad, you have to know the cost of canning, 0:07:51.200 --> 0:07:54.440 the price of pears, apples, peaches, etcetera. And then you 0:07:54.440 --> 0:07:56.720 you had a spread for your risk. Because the models 0:07:56.720 --> 0:07:59.800 are really a little bit shaky. So let's actually let's 0:07:59.800 --> 0:08:03.280 go back. Tell you mentioned the black skulls method, but 0:08:03.680 --> 0:08:08.760 tell us about your beginning on Wall Street where quantitative 0:08:08.760 --> 0:08:11.760 finance was, and when you joined, and then what you 0:08:11.880 --> 0:08:14.120 worked on in your earlier years. You know, I came 0:08:14.160 --> 0:08:18.080 to Goldman. I've been a physicist before that, and then 0:08:18.080 --> 0:08:20.640 I worked for five years of the labs, where I 0:08:20.640 --> 0:08:24.080 already learned a lot of software engineering, which was very useful, 0:08:24.120 --> 0:08:27.800 and I joined Goldman in and the hot thing in 0:08:27.840 --> 0:08:30.240 those days interest rates were coming down from the high 0:08:30.240 --> 0:08:34.480 of sev We've lived through a massive bull market in 0:08:34.520 --> 0:08:38.760 bonds right now. And I worked on black shoals explained 0:08:38.760 --> 0:08:41.560 how to price options on stock. But now people were 0:08:41.600 --> 0:08:45.800 interested in buying options on bonds because as interest rates 0:08:45.800 --> 0:08:48.120 came down, people want to speculate on them going up 0:08:48.120 --> 0:08:50.040 again or going down again. And so there was a 0:08:50.080 --> 0:08:53.760 big market in options on treasury bonds. And the first 0:08:53.800 --> 0:08:55.679 thing I did was work with Fisher Black and a 0:08:55.720 --> 0:08:58.240 colleague of mine, Bill Toy, on trying to extend Black 0:08:58.280 --> 0:09:03.559 Shoals into seeing yield curve things. Bonds and bunds a 0:09:03.600 --> 0:09:06.679 paid coupons rather than stocks. And bonds are very different 0:09:06.720 --> 0:09:10.520 from stocks because stocks have no termination date, but bunds 0:09:10.640 --> 0:09:13.440 have a finite life, and and you really need a 0:09:13.480 --> 0:09:16.280 totally different model. And I worked on something called b 0:09:16.400 --> 0:09:19.160 d T everybody called it Black Dermon Toy, which was 0:09:19.280 --> 0:09:21.440 one of the early models I did. That. The world's 0:09:21.440 --> 0:09:23.880 gotten much more complicated since then. People make much more 0:09:23.880 --> 0:09:27.000 elaborate models. So the way you describe the eighties and 0:09:27.200 --> 0:09:30.760 the sort of explosion in exotic options, it almost sounds 0:09:30.800 --> 0:09:34.080 like a sort of industrial revolution type thing for the 0:09:34.160 --> 0:09:38.800 financial industry. Suddenly you have this big evolution happening in 0:09:39.120 --> 0:09:42.360 products in ways to manage risk, and it kind of 0:09:42.440 --> 0:09:46.440 leads to, um, I guess, more revenue and growth of 0:09:46.480 --> 0:09:50.360 the financial industry as well. Yes, it was everybody. It 0:09:50.480 --> 0:09:54.240 was a globalization. Um, it was the ability to trade 0:09:54.240 --> 0:09:58.960 forim markets suddenly. UM it was Actually I wasn't academic before. 0:09:59.000 --> 0:10:01.520 It was actually very excited. Everybody was waking up every 0:10:01.600 --> 0:10:04.040 day to new products coming out and trying to or 0:10:04.080 --> 0:10:05.840 your bank wanted to issue new products, and you were 0:10:05.840 --> 0:10:08.400 trying to figure out how to value them and hedge 0:10:08.400 --> 0:10:10.880 them because they want to eliminate as much risk for 0:10:10.920 --> 0:10:13.640 themselves as possible. And so there was a there was 0:10:13.679 --> 0:10:17.520 a Yeah, there was a literal sort of efflorescence of 0:10:17.640 --> 0:10:21.240 papers on exotic options and how to hedge volatility and 0:10:21.280 --> 0:10:23.760 the invention I worked on variant swaps, which are ways 0:10:23.760 --> 0:10:28.280 of trading volatility rather than stocks. So how did you 0:10:28.320 --> 0:10:33.480 feel about actually leaving physics and academia and going to 0:10:33.559 --> 0:10:36.680 Wall Street because I imagine it must have been quite 0:10:36.679 --> 0:10:40.400 a different work environment, right, Yes, I was. I was 0:10:40.559 --> 0:10:43.800 very ashamed. You know people who in physics, and even 0:10:43.840 --> 0:10:46.280 I have colleagues today, you are in physics, they go 0:10:46.360 --> 0:10:48.320 into I wrote about this in my book. They're go 0:10:48.320 --> 0:10:51.440 into physics a little bit like um with a religious 0:10:51.480 --> 0:10:54.320 sort of fervor, thinking they're getting to discover something fundamental, 0:10:54.400 --> 0:10:58.560 or try to discover something fundamental, and Um, everybody looks 0:10:58.600 --> 0:11:01.439 down on you if you start to become practical, if 0:11:01.440 --> 0:11:03.480 you start to go out to make a living. We 0:11:03.559 --> 0:11:08.120 all despised people who did that, and eventually I did that. Too. Yeah. 0:11:07.559 --> 0:11:10.640 I think one of the little anecdotes in your book 0:11:10.679 --> 0:11:13.240 was about having some friend who who went to work 0:11:13.280 --> 0:11:18.800 on traffic patterns in the city and feeling sorry for Himmer. Yeah. Yeah, 0:11:18.840 --> 0:11:21.000 even though it sounds like interesting stuff, it is. One 0:11:21.040 --> 0:11:23.480 of the lessons I've learned is that is that actually 0:11:23.480 --> 0:11:25.640 everything is interesting. It's sort of like to see the 0:11:25.640 --> 0:11:27.439 world in a grain of sand. If you look hard enough, 0:11:27.480 --> 0:11:30.280 then a lot of things become interesting. But physics felt 0:11:30.280 --> 0:11:32.079 a bit like a religion, and people look down on 0:11:32.160 --> 0:11:34.080 you when you sort of left the monastery, and I 0:11:34.160 --> 0:11:36.000 felt that for a while. I spent five years at 0:11:36.080 --> 0:11:39.000 Bell Labs, which was interesting, but but it was my 0:11:39.040 --> 0:11:41.280 first experience of working in the corporation and I sort 0:11:41.320 --> 0:11:43.640 of hated it. And then when I came to gold 0:11:43.720 --> 0:11:46.520 to Wall Street, into Goldman, I actually loved it because 0:11:46.720 --> 0:11:49.160 they kind of took an academic interest in this stuff, 0:11:49.520 --> 0:11:53.320 and so you woke up every morning working on something interesting. 0:11:53.520 --> 0:11:55.920 But at the same time there were people who really 0:11:55.920 --> 0:11:58.920 wanted it. Yeah. Actually, I'm one thing I still didn't 0:11:59.000 --> 0:12:03.520 quite understand. So while you were working for Goldman, you 0:12:03.640 --> 0:12:08.559 also published papers regularly and sort of publicized your findings. 0:12:08.880 --> 0:12:11.800 How does that work. The tension of wanting to have 0:12:11.880 --> 0:12:15.880 a model that allows Goldman to profit while also wanting 0:12:15.960 --> 0:12:19.240 to do research that the public can know about and 0:12:19.280 --> 0:12:21.840 you can have your name attached to. Yeah, that's that's 0:12:21.840 --> 0:12:24.800 some I think that's pretty much vanished. People on Wall Street, 0:12:24.920 --> 0:12:28.040 especially with Sabain's Oxley passing ten or fifteen years ago, 0:12:28.640 --> 0:12:31.199 they they don't publish much research anymore. But I grew 0:12:31.280 --> 0:12:35.600 up in an era where people developed new things and 0:12:35.679 --> 0:12:39.160 unless somebody really insisted that they were incredibly proprietary like now, 0:12:39.200 --> 0:12:42.599 for example, algorithmic trading, people people want published papers on. 0:12:42.800 --> 0:12:46.240 But the options business was by and large a sales business. 0:12:46.640 --> 0:12:48.640 You know, you were making money not so much from 0:12:48.640 --> 0:12:53.800 speculating in volatility, but from providing people services and and 0:12:53.840 --> 0:12:56.559 the more you educated your clients, the better they understood 0:12:56.559 --> 0:12:58.960 what you were trying to do. So it was a 0:12:58.960 --> 0:13:01.320 bit of a struggle, but worked for Fisher Black and 0:13:01.840 --> 0:13:04.280 I pushed quite hard. We had a culture where where 0:13:04.559 --> 0:13:07.079 unless somebody it's sort out, where you could never publish. 0:13:07.160 --> 0:13:09.679 And then it became for a few years like they 0:13:09.679 --> 0:13:12.680 had to say you can't publish, rather than you can publish. 0:13:13.160 --> 0:13:17.000 Did you ever get pushed back from your employers, Goldman 0:13:17.200 --> 0:13:21.760 or someone else about I guess the real world application 0:13:21.840 --> 0:13:23.800 of some of the stuff you're doing, or its ability 0:13:23.840 --> 0:13:25.880 to generate money. Like if you were working on a 0:13:25.920 --> 0:13:28.920 project and they couldn't exactly see the commercial interest in it, 0:13:29.000 --> 0:13:33.560 would they ask you to stop? Yeah, I mean, you know, 0:13:33.600 --> 0:13:36.079 I published a lot of papers and I like doing that, 0:13:36.320 --> 0:13:37.880 and I had a big group of people that did 0:13:37.880 --> 0:13:40.360 that and and sometimes actually contact me, and they said 0:13:40.360 --> 0:13:43.280 they didn't realize what a rare environment it was, because 0:13:43.280 --> 0:13:46.200 most people weren't allowed to do that. But we did that. 0:13:46.240 --> 0:13:49.280 But at the same time, our real job was building 0:13:50.040 --> 0:13:53.200 risk management systems for the people that traded equity derivatives, 0:13:53.640 --> 0:13:55.760 and so I would say we sort of earned our 0:13:55.840 --> 0:13:59.000 keep by building software that embedded these models and that 0:13:59.160 --> 0:14:02.079 let the manage that positions. And at the same time 0:14:02.280 --> 0:14:04.800 we had to build new models, and they moral miss 0:14:04.840 --> 0:14:07.559 agreed to let us publish, so they sometimes didn't like it. 0:14:08.559 --> 0:14:11.720 One of the things that I found that maybe everybody 0:14:11.800 --> 0:14:14.240 knew this before me, but that I did not know 0:14:14.360 --> 0:14:16.800 until I read it in your book, was that the 0:14:17.960 --> 0:14:22.600 seven stock market crash caused a permanent change to the 0:14:22.640 --> 0:14:26.720 financial market landscape in terms of how options before that 0:14:26.800 --> 0:14:29.680 crashed price in afterwards, and that had permanently changed the 0:14:29.720 --> 0:14:32.640 way people value things. Can you explain what happened? Yes, 0:14:32.720 --> 0:14:35.400 I can, um, and I'll make you writing a textbook. 0:14:35.560 --> 0:14:37.600 I've just finished the textbook on that right now. But 0:14:38.360 --> 0:14:42.280 but what happened in before seven? People pretty much use 0:14:42.400 --> 0:14:45.000 the Black Sholes model to price options. Is it too 0:14:45.040 --> 0:14:48.600 technical to talk about different strikes? Okay, with different strikes, 0:14:48.920 --> 0:14:50.760 and they still use the same model and the tribute 0:14:50.800 --> 0:14:53.760 to the same risk to the stock that lay underneath 0:14:53.760 --> 0:14:58.280 the option. But after when the market dropped in October, 0:14:58.360 --> 0:15:01.280 in one day, all of a sudden, all hell broke loose, 0:15:01.320 --> 0:15:04.320 and from then on everybody being a bit anthropomorphic, but 0:15:04.400 --> 0:15:08.800 everybody understood that markets tend to crash down and glide up, 0:15:09.040 --> 0:15:10.760 which is kind of what's been happening here too. You 0:15:10.800 --> 0:15:13.480 get a big move down, but you get slow moves up. 0:15:13.840 --> 0:15:16.000 And so if the world is more likely to move 0:15:16.040 --> 0:15:18.840 down dramatically but go up slowly, you ought to charge 0:15:18.880 --> 0:15:21.000 more money for a put which will make money when 0:15:21.000 --> 0:15:24.800 the market drops. And everybody immediately did that, and it's 0:15:24.840 --> 0:15:27.680 been like that ever since. It amazes me that the 0:15:27.720 --> 0:15:30.520 idea that markets don't crash up and only crash down 0:15:30.640 --> 0:15:34.120 was something that wasn't reflected in the market until seven. 0:15:34.160 --> 0:15:36.160 I mean we had market we had stock market crashes 0:15:36.200 --> 0:15:38.840 before then. Yeah, I guess there was no options market 0:15:38.880 --> 0:15:43.200 in in nine. And the options market didn't really get 0:15:43.240 --> 0:15:46.920 big until Black Black Controls published their paper in seventy three. 0:15:47.400 --> 0:15:50.040 And yeah, there was a fourteen year period where where 0:15:50.080 --> 0:15:53.000 people didn't worry too much about the stuff. And it's 0:15:53.000 --> 0:15:54.640 been like that ever since. And in fact, the gold 0:15:54.640 --> 0:15:58.200 market changed in the late nineties because central central banks 0:15:58.280 --> 0:16:01.800 in some central in Switzerland did something other about gold, 0:16:01.800 --> 0:16:05.440 and ever since then, gold tends to crash up when 0:16:05.440 --> 0:16:07.760 the market goes down. Gold doesn't gold. Gold tends to 0:16:07.800 --> 0:16:10.240 go down slowly and go up dramatically, and so you 0:16:10.280 --> 0:16:13.280 get an inverse sort of option behavior that's been there since. 0:16:14.680 --> 0:16:17.680 So all this talk about market crashes is kind of 0:16:17.760 --> 0:16:20.520 reminding me of what's going on right now. In the 0:16:20.600 --> 0:16:24.320 aftermath of the Brexit referendum in the UK, um we 0:16:24.360 --> 0:16:27.120 obviously saw markets sell off after that, but we saw 0:16:27.160 --> 0:16:32.240 a lot of people worrying about what systematic traders, uh, 0:16:32.360 --> 0:16:34.760 you know, like risk parity guys, that sort of thing, 0:16:34.760 --> 0:16:37.520 what they would do. And those guys have been likened 0:16:37.560 --> 0:16:42.560 before to sort of modern portfolio ensures in the sense 0:16:43.000 --> 0:16:46.120 that they could create this sort of feedback loop during 0:16:46.120 --> 0:16:48.400 a big sell off. I love to get your thoughts 0:16:48.400 --> 0:16:51.080 on that. I think that's true. I think anybody who 0:16:51.120 --> 0:16:56.200 behaves mechanically um um is behaving a bit like portfolio insurance, 0:16:56.320 --> 0:16:59.200 and and if people know it's coming, they start to 0:16:59.280 --> 0:17:01.360 try to dodge it. I mean, there's pretty people have 0:17:01.400 --> 0:17:03.480 actually done very well in the best few months because 0:17:04.040 --> 0:17:10.160 they like them they invest equally in bonds, stocks and commodities, 0:17:10.200 --> 0:17:13.720 and all of those things have gone up so um. 0:17:13.760 --> 0:17:16.080 But yes, since they're behaving mechanically, there is a danger 0:17:16.200 --> 0:17:19.439 that they keep doing the same thing. And and you 0:17:19.480 --> 0:17:21.280 can only be clever if you're a small part of 0:17:21.280 --> 0:17:23.040 the of the ocean. But if you're the whole ocean, 0:17:23.080 --> 0:17:26.879 then then and everybody doing the same thing, then your 0:17:26.920 --> 0:17:30.440 models don't work because you're actually affecting affecting the thing 0:17:30.480 --> 0:17:34.080 you're trying to model. So yeah, I think that could happen. Uh. 0:17:34.240 --> 0:17:38.040 You mentioned that part of the reason you did the 0:17:38.080 --> 0:17:40.760 work earlier. Early on in your work, there was a 0:17:40.760 --> 0:17:42.760 lot of demand for it because there was a major 0:17:42.840 --> 0:17:45.840 shift in the direction of interest rates. Right now, interest 0:17:45.920 --> 0:17:48.119 rates are only going in one direction. Every day we 0:17:48.160 --> 0:17:51.960 wake up to new lower rates around the world. Presumably 0:17:52.760 --> 0:17:55.359 one day that will change. It could be next week, 0:17:55.359 --> 0:17:58.640 it could be years from now. When that does happen, 0:17:59.119 --> 0:18:02.240 will we see once again lots of models just being 0:18:02.240 --> 0:18:05.840 completely destroyed and types of portfolios not working, and a 0:18:05.920 --> 0:18:09.800 sort of really really looking at how to do all 0:18:09.800 --> 0:18:12.479 this stuff. That's I mean, I think that's already happening. 0:18:12.480 --> 0:18:14.480 That's a perceptive question. If you look at the thing 0:18:14.480 --> 0:18:17.600 I mentioned earlier, this Black Derman toy model, and essentially 0:18:17.600 --> 0:18:19.639 all the interest rate models that people built, they always 0:18:19.640 --> 0:18:22.960 assumed rates could never go negative. If you try buying software, 0:18:22.960 --> 0:18:25.520 they actually won't let you enter a negative rate. And 0:18:25.560 --> 0:18:27.760 so I don't really work on this stuff anymore, but 0:18:27.800 --> 0:18:29.760 I think a lot of people have been working for 0:18:29.840 --> 0:18:33.840 banks on how do you value options when when there's 0:18:33.840 --> 0:18:36.080 actually a negative interest rate which the previous model just 0:18:36.119 --> 0:18:40.200 didn't allow. And I mean, this stuff is very different 0:18:40.200 --> 0:18:41.880 from physics, I try to point out in my book 0:18:41.880 --> 0:18:43.720 because in physics, once you figure out the way the 0:18:43.760 --> 0:18:46.280 planets work, they say that way, they don't really care 0:18:46.280 --> 0:18:48.120 what you say about them. But when you figure out 0:18:48.160 --> 0:18:50.639 a model for markets and everybody uses it, as Tracy 0:18:50.720 --> 0:18:52.959 was pointing out, it actually starts to affect the thing 0:18:53.000 --> 0:18:56.800 you're modeling, and so no model asks forever you know, 0:18:56.840 --> 0:18:58.879 there's there's some It lives for a while, and then 0:18:58.920 --> 0:19:01.359 people get smarter when the market, which is what happened, 0:19:01.400 --> 0:19:03.840 and he said, when the market suddenly misbehaves and they 0:19:03.840 --> 0:19:05.960 adjust their model, and it's it's sort of an endless 0:19:06.000 --> 0:19:08.840 leap frog in a way. Well, I suppose that gets 0:19:08.880 --> 0:19:11.800 to the heart of one of the major criticisms leveled 0:19:11.880 --> 0:19:15.200 at quantitative finance and at models, which is that how 0:19:15.320 --> 0:19:18.200 useful are they really? We hear all the time about 0:19:18.240 --> 0:19:21.240 like ten sigma events in markets, things that are only 0:19:21.320 --> 0:19:24.400 supposed to happen every you know, one day in five 0:19:24.480 --> 0:19:26.840 million years, and things like that, and they seem to 0:19:26.920 --> 0:19:31.560 keep happening. So clearly the models are missing something, right, Yeah, 0:19:31.640 --> 0:19:35.720 you're right, I think. Yeah, I've written a lot about 0:19:35.720 --> 0:19:38.399 the section. I think models are only good as as 0:19:38.480 --> 0:19:42.200 long as the world stays in the sort of regime 0:19:42.240 --> 0:19:44.440 that you're currently in, and then they provide a good 0:19:44.440 --> 0:19:46.879 way of valuing things as long as things change a 0:19:46.880 --> 0:19:48.480 little bit, not too much. When you move to a 0:19:48.480 --> 0:19:51.920 new regime like negative interest rates or this old central 0:19:51.920 --> 0:19:54.840 bank um sort of the last seven years of risk 0:19:54.880 --> 0:19:59.880 on risk off, then your old models don't work. And yeah, 0:20:00.040 --> 0:20:02.359 kind of like to say, it's idolatry to imagine that 0:20:02.400 --> 0:20:05.720 you can write down an equation that's going to accurately 0:20:05.760 --> 0:20:09.560 reflect the way people behave. Uh So let's sort of 0:20:10.440 --> 0:20:12.240 start or go back to where we talked about in 0:20:12.280 --> 0:20:16.680 the beginning, with the connection of globalization and exotic options. 0:20:17.119 --> 0:20:21.159 In the wake of the Brexit vote, arguably finite the 0:20:21.200 --> 0:20:26.040 world maybe deglobalizing somewhat. What is uh, what is your 0:20:26.040 --> 0:20:29.080 assessment of the financial industry these days? Every day we 0:20:29.119 --> 0:20:34.760 wake up to news about layoffs, retrenchments, large banks divesting 0:20:34.880 --> 0:20:39.640 their their foreign subsidiaries. Where do you see the industry going? 0:20:41.800 --> 0:20:43.960 You know, it goes in cycles. When I when I 0:20:44.000 --> 0:20:46.280 started out, it was very important to be able to 0:20:46.320 --> 0:20:49.240 program and to do quantitative work. Then at some point 0:20:49.880 --> 0:20:52.480 being able to program became a commodity that you could 0:20:52.480 --> 0:20:54.040 give to the I T people and you just did 0:20:54.080 --> 0:20:58.000 theoretical work, which I never really liked. And now now 0:20:58.040 --> 0:21:01.119 exotic options are sort of pretty much a small market 0:21:01.160 --> 0:21:05.280 nobody's interested in that anymore. Everything's done electronically and algorithmically, 0:21:05.320 --> 0:21:09.960 and so software skills for for financial companies and investment 0:21:09.960 --> 0:21:12.960 banks and for hedge funds have become much more important. 0:21:13.080 --> 0:21:15.160 And so I'm looking for the point of the job 0:21:15.200 --> 0:21:18.560 market students now. Students now have to be good programmers 0:21:18.600 --> 0:21:20.280