The World According to Emanuel Derman

DS: You're a creator of models, but you also work with real live traders. How far do models go? Where does their value stop? When can you put too much trust in them?

ED: I've been forced to be fairly pragmatic about them. There was a trading desk head who said that giving somebody a Black-Scholes calculator doesn't make him a trader. The models give you some way of thinking about the problem you're tackling, but they don't necessarily give you the answer.

I like to think of models as a Gedankenexperiments-the imaginary experiments physicists used to try to think about something they couldn't do, like sitting on the edge of a light beam and travelling at the speed of light.

I think that's what models are good for in finance. In most cases the world doesn't really behave in exactly the way as the model you've constructed. You're trying to make a poor approximation of reality, though it has big advantages. You can ask, "What happens if volatility goes up or interest rates go down?" It allows you to stress-test your view of the world in some way and then come up with a price based on what you can understand.

Before Black-Scholes nobody knew a methodology for pricing an option. Some of the things you want to price in the world are horribly nonlinear. You couldn't possibly extrapolate them in your mind.

POSTED — September 9, 2013 — Archives

The Worlds of Yesterday

I never expected to be in the business world, not even a few years before I finally entered it. I got here by a series of languid apparently low-volatility Brownian diffusions within one little world interspersed with sudden jumps to another. The transitions weren't truly unexpected; their probability built up inside me up like a bubble, slowly and predictably.

Growing up in Cape Town, where the college system required that you specialize immediately, I knew I wanted to be a scientist. Somewhat regretful to leave the more expansive world of other things, I nevertheless registered for a Bachelor of Science degree.

POSTED — September 9, 2013 — Archives

A Calculus of Risk

Months before El Niño driven storms battered the Pacific Coast of the U.S., the financial world was making its own preparations for aberrant weather. Beginning last year, an investor could buy or sell a contract whose value depended entirely on fluctuations in temperature or accumulations of rain, hail or snow. These weather derivatives might pay out, for example, if the amount of rainfall at the Los Angeles airport ranged between 17 and 27 inches from October through April. They are a means for an insurer to help provide for future claims by policyholders or a farmer to protect against crop losses. Or the contracts might allow a heating oil supplier to cope with a cash shortfall from a warmer than expected winter by purchasing a heating degree-day floor—a contract that would compensate the company if the temperature failed to fall below 65 degrees as often as expected. “We’re big fans of El Niño because it’s brought us a lot of business,” comments Andrew Freeman, a managing director of Worldwide Weather Trading, a New York City–based firm that writes contracts on rain, snow and temperature.

POSTED — May 5, 1998 — Archives

A Guide for the Perplexed Quant

Quantitative financial modelling seems to employ both the language and techniques of physics, but how similar are the two disciplines? Emanuel Derman comments on the practice of financial modelling and the environment in which it is done.

POSTED — October 10, 2000 — Archives

Financial Engineer of the Year Acceptance Speech

Normally I’m a pretty reticent person, but I have to say that I’m quite unabashedly pleased to be here tonight. I’m very grateful to the IAFE, to SunGard, and to the Selection Committee for having cho- sen me to receive the Financial Engineer of the Year Award. It’s one of the best things that has ever happened to me, for a number of reasons I’d like to spell out, now that I have an uninterrupted opportunity.

POSTED — September 9, 2007 — Archives

Financial Engineer of the Year

SunGard Trading and Risk Systems and the International Association of Financial Engineers (IAFE) today announced that Emanuel Derman has been named the 2000 IAFE/SunGard Financial Engineer of the Year. The award will be presented to Derman on October 12th at the IAFE 2000 Annual conference and dinner in New York City.

POSTED — September 9, 2000 — Archives

New dangers

All this gives rise to various dangers. An ever-tighter squeeze on the profits of financial firms may tempt them to take bigger risks in their proprietary trading operations, in the hope of staying independent long enough to make it into the bulge bracket. A surprising number of them invested heavily in venture capital during the tech boom, and after initially trumpeting stellar returns have now had to write off most of the money.

POSTED — May 5, 2002 — Archives

Physics Envy

Why do so many people cling so hard to the notion of efficient markets? Andrew Lo, an economist at MIT, suggests that they may be suffering from a “peculiar psychological disorder known as ‘physics envy'...We would love to have three laws that explain 99% of economic behaviour; instead, we have about 99 laws that explain maybe 3% of economic behaviour. Nevertheless, we like to talk as if we are dealing with physical phenomena.”

POSTED — May 5, 2002 — Archives

Strike-Adjusted Spread: A New Metric for Estimating the Value of Equity Options (July, 1999)

Investors in equity options experience two problems that compound each other. In contrast to fixed-income and currency markets, there are thousands of underlyers and tens of thousands of options, and each underlyer can have a potentially large volatility skew. How can an options investor gauge which option provides the best relative value?

In this paper, we make use of a method for estimating the fair volatility smile of any equity underlyer from information embedded in the time series of that underlyer’s historical returns. We can then compute the relative richness or cheapness of any particular strike and expiration by examining the option’s Strike-Adjusted Spread, or SAS, the differ- ence between its market implied volatility and its estimated histori- cally-fair volatility.

We obtain fair volatility smiles by estimating the appropriate risk-neu- tral distribution for valuing options on any equity underlyer from that underlyer’s historical returns. The distribution includes the effect of both past price jumps and past shifts in realized volatility. Using this distribution, we can estimate the fair volatility skews for illiquid or thinly-traded single-stock and basket options. We can also forecast changes in the skew from changes in a single options price.

POSTED — July 7, 1999 — Archives

Investing in Volatility

In the beginning was the bond, its value measured simply by its price. Soon, analysts invented better mea- sures of relative bond value: current yield, which led to yield to maturity, followed by the term structure of yields, the zero coupon yield curve, and finally forward rates and the forward rate curve. Their importance reflected the fact that these future rates can be locked in, once and for all, using bond portfolios today. From then on, every interest rate trader and analyst carried in his head an abstract forward rate curve.

POSTED — September 9, 1998 — Archives