36: How A Quant Saw Huge Changes That Took Place on Wall Street

Joe Weisenthal (0:07)

Hello, and welcome to another episode of the Odd Lots Podcast. I'm Joe Weisenthal, managing editor at Bloomberg Markets.

Tracy Alloway (0:15)

And I'm Tracy Alloway, executive editor at Bloomberg Markets.

Joe Weisenthal (0:18)

So Tracy, you know what's something really fun about having a podcast?

Tracy Alloway (0:22)

Okay, tell me, what?

Joe Weisenthal (0:24)

That I can read a book or read an article, and then two days later, say, hey, we should have the author of that in that article or book on to discuss that, and we can do that. I think that's a really cool thing.

Tracy Alloway (0:37)

Is this podcast going to become like Joe's book club?

Joe Weisenthal (0:40)

Yeah, it's basically going to become a podcast. Yeah, basically, it's going to be just here's what Joe read the week before and wants to talk more about.

Tracy Alloway (0:47)

Okay.

Joe Weisenthal (0:48)

No, but I read.

Tracy Alloway (0:49)

Well, I can live with that.

Joe Weisenthal (0:50)

No, it won't be that bad. I read good stuff. But so I recently had the chance to read the book My Life as a Quant by Emanuel Dermen, who was a physicist, theoretical physicist, who eventually joined Wall Street during the Quantitative Revolution and sort of was at all these sort of... There's so much talk about the equations and models that run finance these days.

Tracy Alloway (1:15)

Sure.

Joe Weisenthal (1:15)

And he was at the ground floor of how that all got built up.

Tracy Alloway (1:20)

Oh, well, that's exciting. We've talked plenty about mathematical models and their role in finance on this podcast before. So...

Joe Weisenthal (1:28)

Exactly.

So why not talk to one of the very original practitioners of it? And we have Emmanuel here in studio. So I say, let's get started.

Tracy Alloway (1:40)

Let's do it.

Joe Weisenthal (1:40)

Emmanuel, thanks for joining us.

Emanuel Derman (1:42)

My pleasure. I'm really glad to be here.

Joe Weisenthal (1:44)

So I want to start with something in your book. One of the things that really struck me was you pointed out how the explosion of exotic equity derivatives was very much tied to the globalization of finance after the Cold War ended. And this really seemed like a poignant thing to read right now after the Brexit vote, when it feels like the world is arguably de-globalizing a little bit. Finance seems to be in retreat. But explain to us the connection there, because I thought that that was something that I had never thought of until I read your book.

Emanuel Derman (2:23)

Yeah, that's very interesting. It's funny, nobody's ever mentioned that to me about my book before. I joined equity derivatives at Goldman. I've been in fixed income. I joined equity derivatives in early 1990, and I was in charge of the quantitative strategies group, and we basically supported the options desk. And there was this flowering of interest in exotic options, and it was because of globalization. Essentially, once the Berlin Wall came down, people wanted to invest in foreign stock markets. They didn't want to buy individual stocks, so they used options, which was much simpler. There were indices developed all over the world, from the Nikkei to the CAC to the DAX, and everybody wanted a part of it. And there was also this fashion in finance for them.

Well, it's still going on for sort of not just buying your own country, not just buying the stock of your own company.

Canadian, actually Canadian pension funds used to come to us because Canadian pension funds weren't allowed to buy more than a small amount of foreign stock, and so they would do their exposure through derivatives.

Joe Weisenthal (3:22)

Yeah, so explain that a little bit more. I think people understand what essentially an option is, but explain, well, why are they called exotic options and why do they have an important role in giving people this international exposure?

Emanuel Derman (3:35)

Okay, I'm glad you're asking that. Nobody's ever asked that before. They're called, well, an option is the right, but not the obligation to buy something for a certain price in the future. So, for example, you might have the right to buy IBM a year from today at $100 or whatever it is. And if IBM is trading above $100 at that point, you can buy it for $100, sell it for $110 if it's trading $110, and make $10. And that's what people call a vanilla or a standard call. And there's a put similarly.

But with exotic options, they allowed you to get a much more fine-tuned exposure to different things. So, for example, the first thing I worked on, which was kind of famous, not me individually, but at Goldman, was something called the Nikkei put options, where Goldman issued puts on the Nikkei. And the Nikkei was trading at, I don't remember what it was, at its all-time high of like $29,000 or something like that.