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Physicists graduate from wall street

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An article about quantitative physicist.

An article about quantitative physicist.

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  • 1. NEWS by Jennifer OuellettePhysicists Graduate from Wall Street ver the past decade, the number of fall in value. methods for predicting the stock market. Ph.D. physicists employed in the finan- Hence, “risk management is more techni- Then, in the 1960s and early 1970s, Benoitcial community has increased dramatically. cal than ever,” says Neil Chriss, a vice presi- Mandelbrot—now widely known as theOnce considered something of an anomaly dent and portfolio manager at Goldman “father of fractals” and an IBM Fellow Emeri-on Wall Street and in banking, physicists— Sachs Asset Management, who heads a fledg- tus at IBM’s T. J. Watson Research Center—and their fellow Ph.D.’s in mathematics, ling master’s program in financial mathemat- proposed a model of price variations thatcomputer science, and engineering—have ics at New York University. “The need to eventually evolved into the concept of frac-become a critical element to successful control risk has become a computationally tional Brownian motion in multifractal time.investment strategies, gradually replacing intensive problem, involving the ability to Among other conclusions, Mandelbrot, whomany employees who lack strong statistical price many different assets quickly.” worked at IBM from 1958 to 1993, demon-and analytical backgrounds. Today, quanti- Not surprisingly, the problem-solving strated that wealth acquired on the stocktative methods are commonplace on Wall skills of physicists are useful in this capacity, market is typically acquired during a smallStreet, despite concerns about their predic- as are their abilities to view a problem in a number of highly favorable periods—a find-tive accuracy, and the proliferation of Ph.D. broader context, separate small effects from ing markedly different from the Brownianphysicists in financial activities has made larger ones, and translate intuition about model, which predicts small gains consis-competition for these lucrative positions how something works into formal models. tently over time.more intensive than ever. “Bond traders will try to persuade you that A major turning point occurred in 1973, “Investing is increasingly becoming domi- there’s an emotional aspect that must be when economists Fischer Black and Myronnated by physicists, mathematicians, electri- understood behind certain bonds, but that Scholes devised an equation to calculate thecal engineers, and programmers,” says Adri- really isn’t the case,” says Cooper. “A bond value of options in simple derivative deal-an Cooper, founder and president of Wall is a mathematical instrument which per- ings, best described as an option to buy aStreet Analytics (Palo Alto, CA), where forms according to precise characteristics, stock in the future at a specified price. (Theroughly one-third of the employees are Ph.D. and in order to analyze it properly, you need term derivative is used because the value ofphysicists. Peter Carr, who heads the Equity people capable of understanding the math the contract derives from the value of theDerivatives Research Group at Bank of Amer- behind those characteristics.” u nderl ying s tock. ) T he Black-Sch olesica Securities (New York, NY), recalls that all Although physicists have helped foster the approach was later extended and applied toof his interviewers for his first position at widespread use of quantitative methods in more complex derivatives, particularly inter-Morgan Stanley were physicists. the financial community, the revolution est rate derivatives. Today, more than $14 Physicists in finance generally fall into two actually began with fundamental develop- trillion is invested in derivative securities,categories: those attempting to predict the ments in the mathematics of finance, dating three times as much as is invested in thestock market to achieve superior return, back to 1900, when Louis Bachelier intro- ordinary stocks and bonds from which theyand—more commonly—those who duced a Brownian motion, or “random are derived, and the quantitative analystsuse quanti tati ve methods to walk,” model of price variations. In trading these staggering sums include manyassess and manage investment 1953 , mathema ti cian H arr y Ph.D. physicists.risk, a group known as quantita- Markowitz introduced his “Without the problem-solving skills oftive analysts, or “quants.” Invest- Nobel Pr ize-winning physicists, there would be a great employ-ment banks are highly leveraged w ork o n mean-va ri - ment shortage on Wall Street,” says Steveninstitutions, with book assets that ance analysis, which S hr eve, a profe ss or of ma the matics atoften greatly exceed the value of the gave birth to the Carnegie-Mellon University, because finan-firm. Their goal is to maintain a neutral use of quanti- cial institutions now use quantitative meth-position—a balance between gainers and tative ods to h edge ris k in losers—as various assets in a portfolio rise and DECEMBER 1999 © American Institute of Physics 9 The Industrial Physicist
  • 2. Newstrading derivative securities and other finan- els is to detect the mispricing of an asset,cial instruments. “Physicists didn’t create and make a trade based on [that],” says Nor-that fact, but they helped build the human man Packard, one of PC’s founders.resource needs of the banks.” Along with fellow high-energy physicist The demand for financial-modeling sys- Doyne Farmer, Packard developed a com-tems has driven the formation of numerous puterized system for beating the roulettestart-up companies, many founded by Ph.D. wheel in the 1970s based on the then-physicists drawn to the industry by the tech- emerging field of chaos theory. They subse-nical challenges and potential monetary quently sold it to other entrepreneurs for fur-rewards. (Base salaries on Wall Street can be ther development. The pair then concludedas much as three times that of traditional that financial markets offered another exam-physics positions.) Cooper earned his Ph.D. ple of a complex system that might bein theoretical physics from Stanford Univer- amenable to predictive technology. Theysity, but found himself comparing the career founded PC in 1991, and within a year, thesatisfaction and financial rewards of Ph.D.’s company had signed an exclusive agreementhis age who had followed the traditional to provide predictive signals and automatedcareer path with those who had gone into trading systems to O’Connor and Associatesfinance. “It was pretty clear which direction (now part of Swiss Bank), a highly successfulwas more appealing,” he says. Cooper went Chicago-based trading firm that had madeon to found Wall Street Analytics, which millions in derivatives trading using the This fractaldevelops software for modeling financial sys- Black-Scholes equation. design, known astems for mortgage-pool investments. The skeptics, however, still remain uncon- “Leather,” is wildly com- Nigel Goldenfeld, professor of physics at vinced. “If they could do it, they wouldn’t bethe University of Illinois, Urbana-Cham- wasting their time with a company. They plicated, yet B. B. Mandelbrotpaign (UIUC), earned his Ph.D. from the would just be sitting there buying and selling obtained it by iterating a veryUniversity of Cambridge in England and spe- IBM share options,” Cooper says. simple “dynamical” rule. Financialcializes in statistical, theoretical, and compu- Prevailing attitudes among academicstational physics. His first Ph.D. student at toward physicists working on Wall Street data are also wildly complicated,UIUC ended up w orking for Goldman have changed in the last decade. Emanuel yet many of their features areSachs, which sparked Goldenfeld’s interest Derman, who earned his Ph.D. in physics reproduced by Mandelbrot’sin the physics of finance. Convinced he from Columbia University in the 1970s, iscould improve on the calculation techniques now a managing director at Goldman Sachs multifractal model of priceused, he founded NumeriX in 1996 with fel- and head of its Quantitative Strategies variation, which is alsolow physicists Alexander Sokol and Mitchell Group. He finds that the financial world is of surprising simplicity.Feigenbaum and entrepreneur Michael no longer viewed as a second-rate “alterna-Goodkin. NumeriX is a New York-based ven- tive” career for physicists unable to obtainture that markets fast numerical software positions in academia and industry. Instead, programming isn’t enough to land a job onproducts for derivative-risk management. finance now is a highly desirable first choice, Wall Street. New Ph.D. physicists also need a Physicists attempting to predict the stock as evidenced by the number of tenured pro- basic understanding of options, pricing theo-market look for patterns in the data of stock fessors who have left their academic posi- ry, interest rate theory, and other foundationsprices and foreign-exchange markets. The tions for more lucrative careers in finance. of finance to be considered. “The stakes arePrediction Company (PC), based in Santa Ironically, physicists interested in pursu- higher than they’ve ever been in terms of theFe, New Mexico, is perhaps the best-known ing careers in finance today may have become level of knowledge expected for entry-levelcompany focusing on this sector of finance. victims of their predecessors’ success. “It [quant] positions,” says Chriss.The company develops advanced forecasting used to be a gravy train for physicists and This in cre as ed competi tiveness hastechnologies for prediction and computer- other mathematically oriented people, but spurred the formation of numerous master’sized trading of financial instruments, based now the job market has become saturated,” degree programs in computational financeon the assumption that the stock market is says Carr. Few financial houses are hiring (also called financial engineering or mathe-not completely random but has short-term additional quants, and today the ability to matics in finance) at institutions around thepockets of predictability. “Our task for mod- solve differential equations and perform basic country. Carnegie Mellon University pio- 10 The Industrial Physicist
  • 3. neered the concept in 1994 with a 12-month Although he supports the rationale for in physics, mathematics, and other sub-program combining coursework from four master’s programs in computational finance, jects,” Cooper says. “If the physics depart-separate academic departments: mathemati- Cooper argues the need to preserve the tradi- ments ar en’t protecting the subject ofcal sciences, statistics, computer science, tional focus of university physics programs. physics, who is going to do it?” But Packardand business. His primary concern is that the growing believes the threat of a “brain drain” is not Other schools have followed suit, includ- emphasis on finance as a career option for limited to finance. “Financial markets are theing Purdue University, the Massachusetts physicists could undermine graduate educa- least of physics’ worries,” he says. “The fieldInstitute of Technology, Columbia Universi- tion and turn Ph.D. candidates into mort- is facing an even more severe brain drainty, Cornell University, the University of gage traders too early in their development. from a number of other areas, such as elec-Michigan, the University of Chicago, and Several universities are mulling the possibili- tronics and computer engineering.”New York University. At UIUC, students are ty of running physics and finance graduate As successful as today’s financial modelsable to complete an accelerated master’s in programs in tandem. “These are the universi- have been, there remains substantial roomfinance program in conjunction with their ties that have been entrusted to pass on the for improvement. Although pleased at thephysics Ph.D.’s. learning that has taken generations to amass increased trust placed in quantitative meth- 11 The Industrial Physicist
  • 4. Newsods by the financial community, Thierry the heart of what goes on in financial mar-Kaufmann, a theoretical physicist who heads kets,” Mandelbrot concludes. Underestimat-Purdue’s computational finance master’s pro- ing the frequency of 10 sigma events, a tech-gram, admits that existing models are not nical term for enormous price fluctuations,100% accurate, which poses serious potential can have serious global economic implica-consequences. “Sometimes excessive trust is tions, as evidenced by last year’s fears ofplaced in these quantitative results by people damage to financial markets worldwidewho lack the proper background and make brought on by heavily leveraged trading by avery risky decisions based on them,” he says. hedge fund called Long Term Capital Man-“They can lose a lot of money.” agement. This potential threat was narrowly Although the models used for equity averted by a bailout of the hedge fund paidderivatives have proven fairly robust, many for by major investment houses.surprises still take place in markets heavily Even academic physicists are beginning todependent on bonds and interest-rate move- look more critically at some of the prevailingments and in volatile foreign-exchange mar- modeling assumptions used by the financialkets such as Indonesia. Part of the problem, community. “It’s becoming its own disci-says Goldenfeld, is that many models were pline,” says Derman. In fact, financial marketscreated with an eye to being easily calcula- provide an excellent practical field of study forble. Hence, these models are not faithful to those interested in the behavior of complexthe complexities of real market dynamics. and nonequilibrium dynamical systems“It’s no good having people help you calcu- because there is a wealth of data available.late if you’re using the wrong model,” he “Previous attempts to look at complex sys-says. “You’re getting the wrong answer faster tems, in my view, have not been successfuland more accurately. You want to be able to because people have operated at a level ofget the right answer fast and accurately.” generalities rather than rolling up their Among the sharpest critics has been Man- sleeves and doing honest spadework,” saysdelbrot himself, now Abraham Robinson Pro- Goldenfeld. “What’s happening now isfessor of Mathematical Sciences at Yale Uni- exactly what I had hoped: people are diggingversity, who believes that the current models in and trying to understand the financialseriously underestimate the frequency of markets from a physicist’s perspective ratherlarge fluctuations in stock value. For exam- than that of a financial economist.”ple, Alcatel, a French telecommunications However, he remains a strong proponentequipment manufacturer, experienced severe of the value of firsthand experience withvolatility in its stock prices last year, which financial markets when studying such sys-fell 40% in one day, fell another 3% over the tems. “Thermodynamics was invented bynext three days, and then rebounded by 10% eng inee rs who wan te d to make st eamon the fourth day. “The classical financial engines, not by people thinking about quan-models used for most of this century predict tum states and other abstract concepts,”that such ‘10 sigma’ precipitous events Goldenfeld says.should never happen,” Mandelbrot says, withestimated probabilities of a few millionths of For further reading:a millionth of a millionth of a millionth. In Kelly, K. “Cracking Wall Street,” Wired,reality, such spikes occur quite regularly—as June 1994.often as every month—with probabilities Mandelbrot, B. B. “A Multifractal Walkcloser to a few hundredths. Far from varying Down Wall Street,” Scientific American, Feb-continuously, as such models te nd t o ruary 1999.assume, prices oscillate wildly, often discon- Mandelbrot, B. B. (Ed.). Fractals and Scal -tinuously, at all time scales ing in Finance: Discontinuity, Concentration, “Volatility, far from being a static entity to Risk, Springer-Verlag, New York, 1997; 456be ignored or easily compensated for, is at pp., ISBN 0-387-98363-5. 13 The Industrial Physicist