My Life as a Quant: Reflections on Physics and Finance by Emanuel Derman

Author:Emanuel Derman [Derman, Emanuel]
Language: eng
Format: epub, mobi, pdf
Tags: Investments & Securities, Options, Mathematical & Computational, Finance, Business, Science, Derman; Emanuel, General, Options (Finance), Investment Advisors, Personal Memoirs, Mathematical Physics, Physicists, Biography & Autobiography, Quantum Theory, Physics, Science & Technology, Business & Economics
ISBN: 9780470192733
Google: 9SFgTpq770QC
Amazon: 0471394203
Publisher: Wiley
Published: 2004-01-01T23:00:00+00:00

To hedge one option with another, firms like Goldman needed a model that told you each option's value and its sensitivity to changes in interest rates. The renowned Black-Scholes model for stock options, which Ravi had told me to learn, did not strictly apply to bond options. Stocks are relatively simple; they guarantee no future dividend payments and have no natural termination date, so their future prices are unconstrained. Treasury bonds are much more intricate: Because they promise to repay their principal when they mature, their price on that date is constrained to be par. Furthermore, since all Treasury bonds can be decomposed into a sum of more primitive zero-coupon bonds of varying maturities, they are all interrelated.

My new boss Ravi had heuristically modified the Black-Scholes stock option model to make it work, at least approximately, for short-dated Treasury bond options. He had written a computer program to implement it, and the bond options desk now priced and hedged their options by means of it. As they got more experienced at using it, Peter Freund's desk discovered that Ravi's model was fine for short-terns options but questionable for longer-term ones; it suffered from a variety of theoretical inconsistencies stemming from its inadequate modeling of the longterm behavior of bond prices. It was an ingenious first cut, quickly created to catapult the desk into doing business, but now both the model and its computer interface needed work. A few days after I arrived, Ravi directed me to extend the model and the program. It was a feet-first introduction to working with traders, and much of what I know about the need to be pragmatic and business-oriented as a quant I learned in those first few months working with Ravi and the desk.

From the desks point of view, the greatest hindrance to exploiting the mode] for business was not the theory, but rather the lack of a graphical user interface. Each time a salesperson needed to value an option for a potential trade with a client, he or she had to type in, on one line after another, the bond's current price, maturity, and coupon as well as the option's expiration and strike; then the salesperson had to enter the current short-term interest rate and the bond's assumed future yield volatility One more tap on the return key and the program computed the model's theoretical price and told you how to hedge it with the underlying Treasury bond. If you wanted to compute the option value for a variety of volatilities, expirations or strikes, you had to repeat the same sequence, entering items and hitting return keys all over again.

Setting up a trade could take several days-a typical client might get a quote from Goldman, hang up, call another dealer to get their price, ponder a while, and then call us back the next day to continue the discussion. At that point someone on our desk would have to start running our model again by reentering all the terms of the deal.This slowed down the interaction with clients, and was far too viscous for a growing business.

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