FROM NYTIMES

They Tried to Outsmart Wall Street

By DENNIS OVERBYE

http://www.nytimes.com/2009/03/10/science/10quant.html?ref=science
Emanuel Derman expected to feel a letdown when he left particle physics for a job on Wall Street in 1985.

After all, for almost 20 years, as a graduate student at Columbia and a postdoctoral fellow at institutions like Oxford and the University of Colorado, he had been a spear carrier in the quest to unify the forces of nature and establish the elusive and Einsteinian "theory of everything," hobnobbing with Nobel laureates and other distinguished thinkers. How could managing money compare?

But the letdown never happened. Instead he fell in love with a corner of finance that dealt with stock options.

"Options theory is kind of deep in some way. It was very elegant; it had the quality of physics," Dr. Derman explained recently with a tinge of wistfulness, sitting in his office at Columbia, where he is now a professor of finance and a risk management consultant with Prisma Capital Partners.

Dr. Derman, who spent 17 years at Goldman Sachs and became managing director, was a forerunner of the many physicists and other scientists who have flooded Wall Street in recent years, moving from a world in which a discrepancy of a few percentage points in a measurement can mean a Nobel Prize or unending mockery to a world in which a few percent one way can land you in jail and a few percent the other way can win you your own private Caribbean island.

They are known as "quants" because they do quantitative finance. Seduced by a vision of mathematical elegance underlying some of the messiest of human activities, they apply skills they once hoped to use to untangle string theory or the nervous system to making money.

This flood seems to be continuing, unabated by the ongoing economic collapse in this country and abroad. Last fall students filled a giant classroom at M.I.T. to overflowing for an evening workshop called "So You Want to Be a Quant." Some quants analyze the stock market. Others churn out the computer models that analyze otherwise unmeasurable risks and profits of arcane deals, or run their own hedge funds and sift through vast universes of data for the slight disparities that can give them an edge.

Still others have opened an academic front, using complexity theory or artificial intelligence to better understand the behavior of humans in markets. In December the physics Web site arXiv.org, where physicists post their papers, added a section for papers on finance. Submissions on subjects like "the superstatistics of labor productivity" and "stochastic volatility models" have been streaming in.

Quants occupy a revealing niche in modern capitalism. They make a lot of money but not as much as the traders who tease them and treat them like geeks. Until recently they rarely made partner at places like Goldman Sachs. In some quarters they get blamed for the current breakdown — "All I can say is, beware of geeks bearing formulas," Warren Buffett said on "The Charlie Rose Show" last fall. Even the quants tend to agree that what they do is not quite science.

As Dr. Derman put it in his book "My Life as a Quant: Reflections on Physics and Finance," "In physics there may one day be a Theory of Everything; in finance and the social sciences, you're lucky if there is a useable theory of anything."

Asked to compare her work to physics, one quant, who requested anonymity because her company had not given her permission to talk to reporters, termed the market "a wild beast" that cannot be controlled, and then added: "It's not like building a bridge. If you're right more than half the time you're winning the game." There are a thousand physicists on Wall Street, she estimated, and many, she said, talk nostalgically about science. "They sold their souls to the devil," she said, adding, "I haven't met many quants who said they were in finance because they were in love with finance."

The Physics of Money

Physicists began to follow the jobs from academia to Wall Street in the late 1970s, when the post-Sputnik boom in science spending had tapered off and the college teaching ranks had been filled with graduates from the 1960s. The result, as Dr. Derman said, was a pipeline with no jobs at the end. Things got even worse after the cold war ended and Congress canceled the Superconducting Supercollider, which would have been the world's biggest particle accelerator, in 1993.

They arrived on Wall Street in the midst of a financial revolution. Among other things, galloping inflation had made finances more complicated and risky, and it required increasingly sophisticated mathematical expertise to parse even simple investments like bonds. Enter the quant.

"Bonds have a price and a stream of payments — a lot of numbers," said Dr. Derman, whose first job was to write a computer program to calculate the prices of bond options. The first time he tried to show it off, the screen froze, but his boss was fascinated anyway by the graphical user interface, a novelty on Wall Street at the time.

Stock options, however, were where this revolution was to have its greatest, and paradigmatic, success. In the 1970s the late Fischer Black of Goldman Sachs, Myron S. Scholes of Stanford and Robert C. Merton of Harvard had figured out how to price and hedge these options in a way that seemed to guarantee profits. The so-called Black-Scholes model has been the quants' gold standard ever since.

In the old days, Dr. Derman explained, if you thought a stock was going to go up, an option was a good deal. But with Black-Scholes, it doesn't matter where the stock is going. Assuming that the price of the stock fluctuates randomly from day to day, the model provides a prescription for you to still win by buying and selling the underlying stock and its bonds.

"If you're a trading desk," Dr. Derman explained, "you don't care if it goes up or down; you still have a recipe."