WEBVTT - 36: How A Quant Saw Huge Changes That Took Place on Wall Street 0:00:07.480 --> 0:00:11.520 Hello, and welcome to another episode of the Odd Lots Podcast. 0:00:11.640 --> 0:00:15.440 I'm Joe Wisenthal, Managing editor at Bloomberg Markets, and I'm 0:00:15.480 --> 0:00:19.279 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 --> 0:00:26.840 tell me what that I can read a book or 0:00:26.880 --> 0:00:30.880 read an article and then two days later say, hey, 0:00:30.920 --> 0:00:33.680 we should have the author of that in that article 0:00:33.840 --> 0:00:36.879 or book on to discuss that, and we can do that. 0:00:37.000 --> 0:00:38.879 I think that's a really cool thing. Is this podcast 0:00:38.920 --> 0:00:41.600 going to become like Joe's book Club? It's basically going 0:00:41.640 --> 0:00:45.040 to become Yeah, basically it's gonna be just here's what 0:00:45.159 --> 0:00:47.360 Joe read the week before and wants to talk more about. 0:00:47.920 --> 0:00:50.440 You know, but I, well, I can live. Yeah, it 0:00:50.520 --> 0:00:53.400 won't be that bad. I read good stuff. But uh so, 0:00:53.440 --> 0:00:56.120 I recently had the chance to read the book My 0:00:56.200 --> 0:00:59.680 Life as a quant by Emmanuel Derman, who was a 0:00:59.720 --> 0:01:04.679 physic assist theoretical physicist who eventually joined Wall Street during 0:01:04.720 --> 0:01:09.399 the quantitative revolution and sort of was at all you know, 0:01:09.400 --> 0:01:11.800 all these sort of there's so much talk about the 0:01:11.880 --> 0:01:16.240 equations and models that run finance these days, and he 0:01:16.400 --> 0:01:20.080 was at the ground floor of how that all got 0:01:20.120 --> 0:01:23.480 built up. Oh well, that's exciting. We've talked plenty about 0:01:23.840 --> 0:01:27.560 mathematical models and their role in finance on this podcast before, 0:01:27.720 --> 0:01:32.120 so exactly so, why not? Exactly so? Why not talked 0:01:32.160 --> 0:01:35.400 to one of the very original practitioners of it. And 0:01:35.440 --> 0:01:39.080 we have Emmanuel here in studio, So um, I say, 0:01:39.160 --> 0:01:42.440 let's get started. Let's do it. Emmanuel, thanks for joining us, 0:01:42.720 --> 0:01:45.280 my pleasure. I'm really glad to be here. So I 0:01:45.280 --> 0:01:47.840 want to start with something in your book. One of 0:01:47.880 --> 0:01:50.800 the things that really struck me was you pointed out 0:01:50.960 --> 0:01:57.240 how the explosion of exotic equity derivatives was very much 0:01:57.320 --> 0:02:01.640 tied to the globalization of fine nand after the Cold 0:02:01.640 --> 0:02:04.800 War ended. And there's really seemed like a poignant thing 0:02:04.880 --> 0:02:08.480 to read right now after the Brexit vote, when it 0:02:08.560 --> 0:02:13.560 feels like the world is arguably deglobalizing a little bit. 0:02:13.720 --> 0:02:17.480 Finance seems to be in retreat. But explain to us 0:02:17.600 --> 0:02:20.120 the connection there, because I thought that that was something 0:02:20.760 --> 0:02:23.480 that I had never thought of until I read your book. Yeah, 0:02:23.560 --> 0:02:25.840 that's very interesting. It's funny. Nobody's ever mentioned that to 0:02:25.840 --> 0:02:30.040 me about my book before I joined them. Equity derivatives 0:02:30.120 --> 0:02:32.360 at Goldman. I've been in fixed income. I joined Equit 0:02:32.360 --> 0:02:35.640 Derivatives in early and I was in charge of the 0:02:35.720 --> 0:02:40.520 quantitative Strategies group and we basically supported the options disc 0:02:40.639 --> 0:02:44.480 And there was this flowering of interest in exotic options 0:02:44.560 --> 0:02:47.720 because and it was because of globalization. Essentially, once the 0:02:47.720 --> 0:02:51.280 Berlin Wall came down, people wanted to invest in foreign 0:02:51.560 --> 0:02:55.160 in foreign stock markets. They didn't want to buy individual stocks, 0:02:55.200 --> 0:02:57.639 so they used options, which was much simpler. There were 0:02:57.720 --> 0:03:00.280 indicas developed all over the world, from the neck to 0:03:00.360 --> 0:03:03.359 the keck to the decks, and everybody went to the 0:03:03.400 --> 0:03:05.480 part of it. And there was also this fashion in 0:03:05.520 --> 0:03:08.200 finance forum. Well it's still going on for sort of 0:03:08.200 --> 0:03:10.240 not just buying your own country, not just buying the 0:03:10.240 --> 0:03:14.240 stock of your own company. Canadian actually, Canadian pension funds 0:03:14.360 --> 0:03:16.800 used to come to US because Canadian pension funds weren't 0:03:16.840 --> 0:03:19.720 allowed to buy more than a small amount of foreign stock, 0:03:19.760 --> 0:03:22.280 and so they would do their exposure through derivatives. Yes, 0:03:22.400 --> 0:03:24.720 so explain that a little bit more. I think people 0:03:24.919 --> 0:03:29.239 understand what essentially an option is, but explain, well, why 0:03:29.240 --> 0:03:31.960 are they called exotic options and why do they have 0:03:32.080 --> 0:03:36.200 an important role in giving people this international exposure Okay, 0:03:36.240 --> 0:03:39.000 I'm glad you're asking that. No nobody have asked it before. 0:03:39.120 --> 0:03:42.240 The Well, an option is the right, but not the obligation, 0:03:42.320 --> 0:03:44.760 to buy something for a certain price in the future. So, 0:03:44.840 --> 0:03:48.200 for example, you might have have the right to buy 0:03:48.200 --> 0:03:50.600 IBM a ar from today at a hundred dollars or 0:03:50.600 --> 0:03:52.680 whatever it is, and if IBM s trading above a 0:03:52.720 --> 0:03:54.840 hundred dollars at that point, you can buy it for 0:03:54.880 --> 0:03:56.520 a hundred dollars, sell it for a hundred and ten 0:03:56.560 --> 0:03:58.480 if it's trading on hundred and ten, and make ten bucks. 0:03:58.480 --> 0:04:01.840 And that's what people call vanilla standard call, And there's 0:04:01.840 --> 0:04:05.600 a put similarly, but with exotic options. They allowed you 0:04:05.640 --> 0:04:09.400 to get a much more fine tuned exposure to different things. So, 0:04:09.480 --> 0:04:11.960 for example, the first thing I worked on, which was 0:04:12.040 --> 0:04:14.800 kind of famous, not not me individally, but a Goldman, 0:04:15.240 --> 0:04:18.680 was something called the Nike U the Nike put options, 0:04:18.720 --> 0:04:21.719 where Goldman issued puts on the Nike and the nick 0:04:21.960 --> 0:04:23.600 was trading at I don't remember it was that it's 0:04:23.600 --> 0:04:25.799 all time high of like twenty nine thousand or something 0:04:25.839 --> 0:04:27.440 like that. And there are a lot of people who 0:04:27.440 --> 0:04:29.640 were skeptical about the future of Japan. Rightly as it 0:04:29.680 --> 0:04:33.680 turns out and Goldman sold puts on the Nike. But 0:04:34.200 --> 0:04:36.720 the reason they were exotic was people wanted a bet 0:04:36.720 --> 0:04:38.560 than 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 NICK might go down, but the 0:04:43.480 --> 0:04:45.640 end might strengthen, and so you wouldn't make any money 0:04:45.640 --> 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 0:04:52.320 --> 0:04:54.560 in a guaranteed exchange rate. It didn't matter what the 0:04:54.640 --> 0:04:58.120 yen dollar did. When you exercise your option, you got 0:04:58.120 --> 0:05:01.800 paid in dollars the amount that the unique dropped in percent. 0:05:01.960 --> 0:05:04.200 It was a put am I making sense. So that 0:05:04.279 --> 0:05:07.520 was exotic because so in other words, it's not just 0:05:07.560 --> 0:05:11.480 a planet, it's not a plane embedded in it. Are 0:05:11.600 --> 0:05:16.000 more scenarios and more hedges, yes, or actually less in 0:05:16.040 --> 0:05:18.240 a sense. You if you bought an ordery put on 0:05:18.240 --> 0:05:20.560 the Nick, you would be exposed to both the yen 0:05:20.680 --> 0:05:23.159 dollar and to the Nike, and this way you remove 0:05:23.200 --> 0:05:25.760 the end dollar. So people would do this kind of stuff, 0:05:25.839 --> 0:05:29.160 or people would buy knockout options, which were very popular, 0:05:29.279 --> 0:05:32.120 which is an option that gives you money if it's 0:05:32.160 --> 0:05:35.599 called gives you money if the stock rises, but gets 0:05:35.920 --> 0:05:37.800 knocked out if the stock drops too low, if the 0:05:37.800 --> 0:05:40.000 stock drops too high. All of these ways were basically 0:05:40.040 --> 0:05:44.960 ways of making speculative bets. By putting up less money 0:05:44.960 --> 0:05:46.960 than you would for vanial option, you were betting on 0:05:47.000 --> 0:05:49.840 a smaller range of probabilities than just what was what 0:05:49.960 --> 0:05:53.599 was reflected in an ordinary option. And Emmanuel, one thing 0:05:54.000 --> 0:05:56.440 I always wonder about when it comes to these sorts 0:05:56.480 --> 0:05:59.880 of exotic options and instruments is you're allowing me in 0:06:00.000 --> 0:06:03.760 investor to sort of fine tune their risk. But how 0:06:03.800 --> 0:06:08.400 do the banks that are actually offering these kind of products, 0:06:08.400 --> 0:06:11.400 how did they manage their risk? Because things like knockout 0:06:11.440 --> 0:06:15.520 options can be you know, um kind of painful for 0:06:15.600 --> 0:06:19.320 the issuer, right, yes, So I mean that that was 0:06:19.360 --> 0:06:22.880 my job exactly. We we Golden for example, issued these 0:06:22.920 --> 0:06:26.240 exotic options, but if you sold them to somebody, you 0:06:26.240 --> 0:06:28.760 didn't want to suffer when they made money. So you 0:06:28.800 --> 0:06:31.360 had to head yourself. And you couldn't just buy an 0:06:31.360 --> 0:06:33.640 exotic option from one person and sell it to another, 0:06:33.960 --> 0:06:37.760 So you had to deconstructed and what black shoals and 0:06:37.800 --> 0:06:40.400 all the extensions of option pricing do is tell you 0:06:41.000 --> 0:06:44.000 essentially how to synthesize an option or an exotic option 0:06:44.120 --> 0:06:47.240 from the underlying which is the currency and the and 0:06:47.320 --> 0:06:52.360 the nique itself. Am I making sense? I'm not sure? No? Absolutely, Okay. 0:06:52.400 --> 0:06:54.719 So so the models we worked on, which I did 0:06:54.760 --> 0:06:58.560 for ten years, told you how to dynamically every day 0:06:58.720 --> 0:07:02.080 trade the end dollar and every day trade the nika 0:07:02.600 --> 0:07:06.119 in order to replicate what you were selling to somebody else. 0:07:06.200 --> 0:07:08.000 You were selling them a package and now you had 0:07:08.120 --> 0:07:11.240 created for yourself so that when they wont you wouldn't lose. Yeah. 0:07:11.240 --> 0:07:14.040 I love the way in your book you essentially described 0:07:14.040 --> 0:07:20.600 it as you're buying raw material, some combination of equity, cash, 0:07:20.760 --> 0:07:24.520 the end, and then you're repackaging it and basically selling 0:07:24.520 --> 0:07:28.640 it as a mark up like any other manufacturer done. Honestly, 0:07:28.680 --> 0:07:31.040 that's what it is. You're you're a middleman, you're a 0:07:31.040 --> 0:07:35.160 market maker, You're you're a wholesaler. You're buying complex stuff 0:07:35.200 --> 0:07:38.000 that people want to sell, and you're decomposing it into 0:07:38.000 --> 0:07:42.559 its constituents, or you're selling people complex stuff and making 0:07:42.560 --> 0:07:44.920 it out of out of simple constituents. So it's really 0:07:45.160 --> 0:07:46.480 I think, I say in my book, it's a bit 0:07:46.520 --> 0:07:48.440 like fruit salad. If you want to know what you 0:07:48.440 --> 0:07:50.360 should charge for fruit salad, you have to know the 0:07:50.360 --> 0:07:53.560 cost of canning, the price of pears, apples, peaches, etcetera. 0:07:53.600 --> 0:07:55.760 And then you you had a spread for your risk. 0:07:55.880 --> 0:07:58.720 Because the models are really a little bit shaky. So 0:07:58.840 --> 0:08:01.640 let's actually let's go back. Tell you you mentioned the 0:08:01.640 --> 0:08:06.120 black skulls method, but tell us about your beginning on 0:08:06.240 --> 0:08:11.040 Wall Street where quantitative finance was, and when you joined, 0:08:11.160 --> 0:08:13.400 and then what you worked on in your earlier years. 0:08:13.520 --> 0:08:17.040 You know, I came to Goldman, I've been a physicist 0:08:17.080 --> 0:08:19.120 before that, and then I worked for five years of 0:08:19.240 --> 0:08:22.600 the labs, where I already learned a lot of software engineering, 0:08:23.160 --> 0:08:26.960 which was very useful, and I joined Goldman in and 0:08:27.240 --> 0:08:29.320 the hot thing in those days interest rates were coming 0:08:29.360 --> 0:08:33.440 down from the high of seventy nine. We've lived through 0:08:33.440 --> 0:08:36.520 a massive bull market in bonds right now. And I 0:08:36.679 --> 0:08:40.280 worked on black shoals explained how to price options on stock. 0:08:40.840 --> 0:08:43.880 But now people were interested in buying options on bonds 0:08:44.400 --> 0:08:47.439 because as interest rates came down, people wanted to speculate 0:08:47.480 --> 0:08:49.520 on them going up again or going down again, and 0:08:49.600 --> 0:08:52.359 so there was a big market and options on treasury bonds, 0:08:52.559 --> 0:08:55.120 And the first thing I did was work with Fisher 0:08:55.200 --> 0:08:57.360 Black and a colleague of mine, Bill Toy, on trying 0:08:57.360 --> 0:09:02.480 to extend Black shoals into seeing yield curve things bonds 0:09:02.559 --> 0:09:06.080 and bonds that paid coupons rather than stocks. And bonds 0:09:06.120 --> 0:09:09.440 are very different from stocks because stocks have no termination date, 0:09:10.000 --> 0:09:13.200 but bonds have a finite life, and and you really 0:09:13.240 --> 0:09:16.040 need a totally different model, And I worked on something 0:09:16.040 --> 0:09:18.720 called b d T everybody called it Black Dermon Toy, 0:09:18.760 --> 0:09:20.680 which was one of the early models I did. That. 0:09:21.040 --> 0:09:23.480 The world's gotten much more complicated since then. People make 0:09:23.559 --> 0:09:26.319 much more elaborate models. So the way you describe the 0:09:26.360 --> 0:09:29.720 eighties and the sort of explosion in exotic options, it 0:09:30.040 --> 0:09:33.800 almost sounds like a sort of industrial revolution type thing 0:09:33.920 --> 0:09:37.840 for the financial industry. Suddenly you have this big evolution 0:09:38.080 --> 0:09:41.680 happening in products in ways to manage risk, and it 0:09:41.920 --> 0:09:45.400 kind of leads to, um, I guess, more revenue and 0:09:45.840 --> 0:09:50.120 growth of the financial industry as well. Yes, it was everybody. 0:09:50.320 --> 0:09:53.960 It was a globalization. Um, it was the ability to 0:09:54.000 --> 0:09:58.200 trade farm markets suddenly. Um it was Actually I wasn't 0:09:58.240 --> 0:10:01.160 academic before. It was actually very excite. Everybody was waking 0:10:01.200 --> 0:10:03.480 up every day to new products coming out and trying 0:10:03.480 --> 0:10:05.640 to or your bank wanted to issue new products, and 0:10:05.679 --> 0:10:08.040 you were trying to figure out how to value them 0:10:08.040 --> 0:10:10.480 and hedge them because they want to eliminate as much 0:10:10.559 --> 0:10:13.320 risk for themselves as possible. And so there was a 0:10:13.400 --> 0:10:15.800 there was a Yeah, there was a literal sort of 0:10:16.559 --> 0:10:20.320 efflorescence of papers on exotic options and how to hedge 0:10:20.360 --> 0:10:23.400 volatility and the invention I worked on variant swaps, which 0:10:23.400 --> 0:10:28.000 are ways of trading volatility rather than stocks. So how 0:10:28.000 --> 0:10:32.400 did you feel about actually leaving physics and academia and 0:10:32.480 --> 0:10:36.200 going to Wall Street because I imagine it must have 0:10:36.200 --> 0:10:39.600 been quite a different work environment, right, Yes, I was. 0:10:40.160 --> 0:10:43.400 I was very ashamed. You know, people who in physics, 0:10:43.480 --> 0:10:46.000 and even I have colleagues today who are in physics, 0:10:46.000 --> 0:10:48.080 they go into I wrote about this in my book. 0:10:48.080 --> 0:10:50.800 They're going into physics a little bit like um with 0:10:50.880 --> 0:10:53.360 a religious sort of fervor, thinking they're getting to discover 0:10:53.480 --> 0:10:57.840 something fundamental, or try to discover something fundamental, and Um, 0:10:57.880 --> 0:11:01.200 everybody looks down on you if you start to become practical, 0:11:01.320 --> 0:11:02.880 if you start to go out to make a living. 0:11:03.440 --> 0:11:05.640 We all despised people who did that, and eventually I 0:11:05.679 --> 0:11:09.680 did that too. Yeah. I think one of the little 0:11:09.679 --> 0:11:12.319 anecdotes in your book was about having some friend who 0:11:12.520 --> 0:11:15.120 who went to work on traffic patterns in the city 0:11:15.200 --> 0:11:19.160 and feeling sorry for him. Er. Yeah. Yeah. Even though 0:11:19.200 --> 0:11:21.199 it sounds like interesting stuff, it is. One of the 0:11:21.280 --> 0:11:24.320 lessons I've learned is that is that everything is interesting. 0:11:24.360 --> 0:11:26.080 It's sort of like to see the world in a 0:11:26.080 --> 0:11:27.679 grain of sand. If you look hard enough, then a 0:11:27.720 --> 0:11:30.520 lot of things become interesting. But physics felt a bit 0:11:30.600 --> 0:11:32.439 like a religion, and people look down on you when 0:11:32.440 --> 0:11:34.560 you sort of left the monastery, and I felt that 0:11:34.600 --> 0:11:36.640 for a while. I spent five years at Bell Labs, 0:11:36.679 --> 0:11:39.720 which was interesting, but but it was my first experience 0:11:39.720 --> 0:11:41.920 of working in a corporation and I sort of hated it. 0:11:42.440 --> 0:11:44.800 And then when I came to gold to Wall Street 0:11:44.840 --> 0:11:47.240 into Goldman, I actually loved it because they kind of 0:11:47.240 --> 0:11:50.120 took an academic interest in this stuff, and so you 0:11:50.200 --> 0:11:53.960 woke up every morning working on something interesting. But at 0:11:54.000 --> 0:11:57.160 the same time there were people who really wanted it. Yeah. Actually, 0:11:57.320 --> 0:12:00.240 I am one thing I still didn't quite understand. So 0:12:00.679 --> 0:12:05.319 while you were working for Goldman, you also published papers 0:12:05.320 --> 0:12:09.680 regularly and sort of publicized your findings how does that work? 0:12:09.720 --> 0:12:13.000 The tension of wanting to have a model that allows 0:12:13.160 --> 0:12:17.760 Goldman to profit while also wanting to do research that 0:12:18.040 --> 0:12:19.760 the public can know about and you can have your 0:12:19.840 --> 0:12:23.079 name attached to. Yeah, that's that's some I think that's 0:12:23.080 --> 0:12:25.880 pretty much vanished. People on Wall Street, especially with Sabain's 0:12:25.920 --> 0:12:29.440 Oxley passing ten or fifteen years ago, they they don't 0:12:29.440 --> 0:12:31.679 publish much research anymore. But I grew up in an 0:12:31.679 --> 0:12:36.920 era where people developed new things and unless somebody really 0:12:36.920 --> 0:12:39.720 insisted that they were incredibly proprietary, like now, for example, 0:12:39.760 --> 0:12:43.760 algorithmic trading, people people won't published papers on. But the 0:12:43.760 --> 0:12:46.880 options business was by and large a sales business. You know, 0:12:47.080 --> 0:12:50.080 you were making money not so much from speculating in volatility, 0:12:50.120 --> 0:12:54.280 but from providing people services and and the more you 0:12:54.360 --> 0:12:56.920 educated your clients, the better they understood what you were 0:12:56.920 --> 0:12:59.720 trying to do. So it was a bit of a struggle, 0:12:59.760 --> 0:13:02.720 but I worked for Fisher Black and I pushed quite hard. 0:13:02.760 --> 0:13:05.800 We had a culture where where unless somebody it's sort out, 0:13:05.840 --> 0:13:08.560 where you could never publish. And then it became for 0:13:08.640 --> 0:13:10.920 a few years like they had to say you can't publish, 0:13:11.040 --> 0:13:14.480 rather than you can publish. Did you ever get pushed 0:13:14.480 --> 0:13:19.360 back from your employers, Goldman or someone else about I 0:13:19.360 --> 0:13:22.559 guess the real world application of some of the stuff 0:13:22.559 --> 0:13:25.160 you're doing, or its ability to generate money. Like if 0:13:25.160 --> 0:13:27.320 you were working on a project and they couldn't exactly 0:13:27.360 --> 0:13:29.960 see the commercial interest in it, would they ask you 0:13:30.000 --> 0:13:34.280 to stop? Yeah, I mean, you know, I published a 0:13:34.280 --> 0:13:36.520 lot of papers and I like doing that, and I 0:13:36.559 --> 0:13:38.640 had a big group of people that did that, and 0:13:38.640 --> 0:13:40.800 and sometimes actually contact me, and they said they didn't 0:13:40.840 --> 0:13:43.800 realize what a rare environment it was, because most people 0:13:43.800 --> 0:13:46.319 weren't allowed to do that. But we did that. But 0:13:46.360 --> 0:13:50.280 at the same time, our real job was building risk 0:13:50.320 --> 0:13:53.800 management systems for the people that traded equity derivatives, and 0:13:53.880 --> 0:13:56.080 so I would say we sort of earned our keep 0:13:56.120 --> 0:13:59.360 by building software that embedded these models and that let 0:13:59.360 --> 0:14:02.400 them manage that positions. And at the same time we 0:14:02.400 --> 0:14:05.120 had to build new models, and they moral less agreed 0:14:05.160 --> 0:14:07.560 to let us publish, so they sometimes didn't like it. 0:14:08.600 --> 0:14:11.760 One of the things that I found that maybe everybody 0:14:11.840 --> 0:14:14.240 knew this before me, but that I did not know 0:14:14.360 --> 0:14:16.839 until I read it in your book, was that the 0:14:18.000 --> 0:14:22.640 seven stock market crash caused a permanent change to the 0:14:22.680 --> 0:14:26.760 financial market landscape in terms of how options before that 0:14:26.800 --> 0:14:29.720 crashed price in afterwards, and that had permanently changed the 0:14:29.720 --> 0:14:32.680 way people value things. Can you explain what happened? Yes, 0:14:32.760 --> 0:14:35.440 I can, um, and I'll make you writing a textbook. 0:14:35.600 --> 0:14:38.400 I've just finished the textbook on that right now. But 0:14:38.400 --> 0:14:42.360 but what happened in before seven? People pretty much used 0:14:42.400 --> 0:14:45.080 the Black Sholes model to price options. Is it too 0:14:45.080 --> 0:14:48.640 technical to talk about different strikes? Okay, with different strikes, 0:14:48.960 --> 0:14:50.800 and they still use the same model and the tribute 0:14:50.800 --> 0:14:53.720 to the same risk to the stock that lay underneath 0:14:53.800 --> 0:14:58.320 the option. But after seven, 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 --> 0:15:04.360 and from then on everybody being a bit anthropomorphic, but 0:15:04.400 --> 0:15:08.840 everybody understood that markets tend to crash down and glide up, 0:15:09.040 --> 0:15:10.800 which is kind of what's been happening here too. You 0:15:10.840 --> 0:15:13.480 get a big move down, but you get slow moves up. 0:15:13.880 --> 0:15:16.040 And so if the world is more likely to move 0:15:16.080 --> 0:15:18.880 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 0:15:21.040 --> 0:15:24.840 the market drops. And everybody immediately did that, and it's 0:15:24.840 --> 0:15:27.720 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 --> 0:15:34.160 was something that wasn't reflected in the market until seven. 0:15:34.200 --> 0:15:36.200 I mean we had market we had stock market crashes 0:15:36.240 --> 0:15:38.840 before then. Yeah, I guess there was no options market 0:15:38.880 --> 0:15:43.240 in in nine. And the options market didn't really get 0:15:43.280 --> 0:15:47.040 big until Black Black Controls published their paper in seventy three. 0:15:47.440 --> 0:15:50.040 And yeah, there was a fourteen year period where where 0:15:50.120 --> 0:15:53.040 people didn't worry too much about the stuff. And it's 0:15:53.040 --> 0:15:54.640 been like that ever since. And in fact, the gold 0:15:54.680 --> 0:15:58.200 market changed in the late nineties because central central banks 0:15:58.320 --> 0:16:01.800 in some central in Switzerland did something other about gold, 0:16:01.840 --> 0:16:05.480 and ever since then, gold tends to crash up when 0:16:05.480 --> 0:16:07.800 the market goes down. Gold doesn't God, Gold tends to 0:16:07.800 --> 0:16:10.240 go down slowly and go up dramatically, and so you 0:16:10.320 --> 0:16:13.320 get an inverse sort of option behavior that's been there since. 0:16:14.720 --> 0:16:17.720 So all this talk about market crashes is kind of 0:16:17.800 --> 0:16:20.560 reminding me of what's going on right now. In the 0:16:20.640 --> 0:16:24.320 aftermath of the Brexit referendum in the UK. Um we 0:16:24.400 --> 0:16:27.120 obviously saw market sell off after that, but we saw 0:16:27.160 --> 0:16:32.280 a lot of people worrying about what systematic traders, uh, 0:16:32.400 --> 0:16:34.760 you know, like risk parity guys that sort of thing 0:16:34.800 --> 0:16:37.520 what they would do. And those guys have been likened 0:16:37.600 --> 0:16:42.560 before to sort of modern portfolio insurers in the sense 0:16:43.000 --> 0:16:46.160 that they could create this sort of feedback loop during 0:16:46.160 --> 0:16:48.440 a big sell off. I'd love to get your thoughts 0:16:48.440 --> 0:16:51.120 on that. I think that's true. I think anybody who 0:16:51.160 --> 0:16:56.240 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 0:16:59.320 --> 0:17:01.400 try to dodge it. I mean, there's pretty people have 0:17:01.400 --> 0:17:03.520 actually done very well in the best few months because 0:17:04.080 --> 0:17:09.399 they like them they invest equally in in bonds, stocks 0:17:09.400 --> 0:17:11.760 and commodities, and all of those things have gone up 0:17:12.840 --> 0:17:15.600 so um. But yes, since they're behaving mechanically, there is 0:17:15.600 --> 0:17:18.760 a danger that they keep doing the same thing. And 0:17:18.760 --> 0:17:20.960 and you can only be clever if you're a small 0:17:21.000 --> 0:17:22.560 part of the of the ocean. But if you're the 0:17:22.560 --> 0:17:25.160 whole ocean, then then and everybody doing the same thing, 0:17:25.200 --> 0:17:30.200 then your models don't work because you're actually affecting affecting 0:17:30.200 --> 0:17:32.200 the thing you're trying to model. So yeah, I think 0:17:32.200 --> 0:17:35.800 that could happen. Uh. You mentioned that part of the 0:17:35.840 --> 0:17:40.160 reason you did the work earlier. Early on in your work, 0:17:40.440 --> 0:17:42.240 there was a lot of demand for it because there 0:17:42.280 --> 0:17:44.720 was a major shift in the direction of interest rates. 0:17:45.080 --> 0:17:47.480 Right now, interest rates are only going in one direction. 0:17:47.560 --> 0:17:50.240 Every day we wake up to new lower rates around 0:17:50.280 --> 0:17:54.440 the world. Presumably one day that will change. It could 0:17:54.480 --> 0:17:57.560 be next week, it could be years from now. When 0:17:57.600 --> 0:18:01.439 that does happen, will we see once again lots of 0:18:01.480 --> 0:18:04.840 models just being completely destroyed and types of portfolio is 0:18:04.880 --> 0:18:08.160 not working and a sort of really really looking at 0:18:08.800 --> 0:18:11.440 how to do all this stuff. That's I mean, I 0:18:11.440 --> 0:18:13.919 think that's already happening. That's a perceptive question. If you 0:18:13.960 --> 0:18:15.960 look at the thing I mentioned earlier, this Black Derman 0:18:16.000 --> 0:18:18.760 toy model, and essentially all the interest rate models that 0:18:18.840 --> 0:18:21.320 people built, they always assumed rates could never go negative. 0:18:21.640 --> 0:18:23.840 If you try buying software, they actually won't let you 0:18:23.920 --> 0:18:26.880 enter a negative rate. And so I don't really work 0:18:26.880 --> 0:18:28.800 on this stuff anymore, but I think a lot of 0:18:28.800 --> 0:18:31.159 people have been working for banks on how do you 0:18:31.320 --> 0:18:35.080 value options when when there's actually a negative interest rate 0:18:35.080 --> 0:18:38.800 which the previous model just didn't allow. And I mean, 0:18:39.160 --> 0:18:41.119 this stuff is very different from physics. I try to 0:18:41.160 --> 0:18:43.000 point out in my book because in physics, once you 0:18:43.000 --> 0:18:45.439 figure out the way the planets work, they say that 0:18:45.480 --> 0:18:47.160 way they don't really care what you say about them. 0:18:47.200 --> 0:18:49.280 But when you figure out a model for markets and 0:18:49.320 --> 0:18:52.040 everybody uses it, as Tracy was pointing out, it actually 0:18:52.040 --> 0:18:54.679 starts to affect the thing you're modeling, and so no 0:18:54.800 --> 0:18:58.200 model asks forever, you know, there's there's some It lives 0:18:58.200 --> 0:19:00.399 for a while, and then people get smarter when market 0:19:00.720 --> 0:19:02.240 which is what happened, and he said, when the market 0:19:02.280 --> 0:19:05.280 suddenly misbehaves and they adjust their model, and it's it's 0:19:05.320 --> 0:19:07.560 sort of an endless leap frog in a way. Well, 0:19:08.000 --> 0:19:10.159 I suppose that gets to the heart of one of 0:19:10.160 --> 0:19:14.040 the major criticisms leveled at quantitative finance and at models, 0:19:14.040 --> 0:19:17.200 which is that how useful are they really? We hear 0:19:17.280 --> 0:19:20.680 all the time about like ten sigma events in markets, 0:19:20.680 --> 0:19:22.719 things that are only supposed to happen every you know, 0:19:23.200 --> 0:19:26.000 one day in five million years, and things like that, 0:19:26.080 --> 0:19:29.919 and they seem to keep happening. So clearly the models 0:19:29.920 --> 0:19:34.800 are missing something, right, Yeah, you're right, I think. Yeah, 0:19:34.840 --> 0:19:36.879 I've written a lot about the section. I think models 0:19:36.920 --> 0:19:39.840 are only good as as long as the world stays 0:19:41.200 --> 0:19:43.480 in the sort of regime that you're currently in, and 0:19:43.480 --> 0:19:45.680 then they provide a good way of valuing things as 0:19:45.680 --> 0:19:47.760 long as things change a little bit, not too much. 0:19:47.840 --> 0:19:50.080 When you move to a new regime like negative interest 0:19:50.160 --> 0:19:53.720 rates or this old central bank um sort of the 0:19:53.760 --> 0:19:56.520 last seven years of risk on risk off, then your 0:19:56.560 --> 0:20:00.399 old models don't work. And yeah, A kind of like 0:20:00.480 --> 0:20:02.880 to say, it's idolatry to imagine that you can write 0:20:02.920 --> 0:20:06.440 down an equation that's going to accurately reflect the way 0:20:06.480 --> 0:20:11.119 people behave. Uh So let's sort of start or go 0:20:11.200 --> 0:20:13.080 back to where we talked about in the beginning, with 0:20:13.119 --> 0:20:17.640 the connection of globalization and exotic options. In the wake 0:20:17.720 --> 0:20:23.760 of the Brexit vote, arguably finite the world maybe deglobalizing somewhat. 0:20:24.400 --> 0:20:27.800 What is uh, what is your assessment of the financial 0:20:27.800 --> 0:20:30.040 industry these days? Every day we wake up to news 0:20:30.119 --> 0:20:37.399 about layoffs, retrenchments, large banks divesting their their foreign subsidiaries. 0:20:38.119 --> 0:20:42.159 Where do you see the industry going? You know, it 0:20:42.200 --> 0:20:44.800 goes in cycles. When I when I started out, it 0:20:44.960 --> 0:20:47.119 was very important to be able to program and to 0:20:47.160 --> 0:20:50.399 do quantitative work. Then at some point being able to 0:20:50.400 --> 0:20:52.879 program became a commodity that you could give to the 0:20:52.880 --> 0:20:55.080 I T people and you just did theoretical work, which 0:20:55.160 --> 0:20:59.120 I never really liked. And now now exotic options are 0:20:59.320 --> 0:21:02.240 sort of pretty much a small market. Nobody's interested in 0:21:02.280 --> 0:21:06.520 that anymore. Everything's done electronically and algorithmically, and so software 0:21:06.560 --> 0:21:10.600 skills for for financial companies and investment banks and for 0:21:10.680 --> 0:21:14.000 hedge funds have become much more important. And so I'm 0:21:14.040 --> 0:21:16.160 looking for the point of the job market students now. 0:21:16.320 --> 0:21:19.080