My Life as a Quant (33 page)

The QS group Jeff and I inherited was a hodgepodge mix of about four employees and five long-term consultants who together occupied a messy warren of shared offices and cubicles in a corner of Equities on the twenty-ninth floor of 85 Broad Street. I liked the augury of my new phone number, 902-0129, whose last four digits I superstitiously interpreted to indicate that I was Number One on Twenty-Nine.

We were ideally located about forty feet away from the derivatives trading desk, distant enough so you could concentrate quietly when necessary, but sufficiently close to feel part of the same team. You could stroll over and talk to traders about the market at the end of the day without seeming too pointed. This proximity to the trading desk lasted only six months; after that, as both QS and the derivatives business expanded, we moved a few floors away and lost our sense of community. From then on it became much harder to acquire the skill of communicating with traders, one of the more difficult tasks facing a new quant.

Our offices were crowded and littered; piles of documents blocked the corridors between the cubicles, and the disorganization made a bad impression on clients who occasionally visited the sales and trading floor. Periodically one of the heads of Equities would walk by and threaten reprisals if order were not restored. The worst culprit was Bill Toy, whose desk and office floor was stacked one to two feet high with every squirreled-away piece of paper he had ever read or written on—he was unable to part with anything. When Bill used to complain about wanting to make more money, Jeff would tell him that the easiest way to get a $50,000 raise was to clean up his desk, and I think it was true.

The only traditional financial modeler in Fischer's ex-group was Piotr Karasinski, then still busy writing the paper on the Black-Karasinski yield-curve model. Most of the other members were talented hardware and software consultants who had been hired and managed by Jeff to focus on electronic stock-trading software. Long before most people, Fischer had foreseen the application of information technology to trading; in 1971 he had written an influential paper entitled
Toward a Fully Automated Exchange
. Now, together with Jeff, he was nudging the firm in that direction. It was prescient work, but a little early; if he had lived another ten years to witness the growth of computerized exchanges he would have had a riper laboratory in which to test his ideas.

The hardware focus of the QS consultants permeated our surroundings. Shelves piled high with old computer parts ran along the walls of the long, narrow, dark office I inhabited, reminding me of the garbage dump of broken robot parts that C-3PO used to repair himself in the movie
Star Wars
. I remember the look of suppressed puzzlement on John Hull's face when he visited me there that year and found that people he thought of as quants were spending so much time and energy on technology. In truth, though, that was what the business needed. I had seen over and over again during the past few years that a model only gains its power when embedded in a useable trading system.

The QS consultants were paid by the hour and many of them worked the shifted day of computer geeks, starting late in the morning and programming away spacily with CD players on their desk and headphones on their ears. This was an unfamiliar and unprofessional look in 1990, especially on a floor that clients visited, and we tried to bring a more superficially businesslike look to the group. It wasn't easy. One consultant who left his CD player inside his unlocked desk drawer overnight found it gone one morning. He spent the first half of that day speaking to Security in an attempt to find it, and the second half arguing that we should reimburse him for the stolen player. It was with great difficulty that I refrained from pointing out that he had spent the last eight hours looking for the CD player, and that his hourly rate for that time had already exceeded the cost of it.

The Equities floor I now worked on had a character very different from the Fixed Income atmosphere I knew so well. In 1990, Equities had not yet lost its aura of a small, exclusive, old-world club. Partners had their daily lunch brought to them on a large silver tray delivered by a gracious, white-coated food server, each plate covered by its own elegant warming dome. There were luxuries for less important people, too. Employees on the trading floor received free food during the day; when you arrived in the morning, a gentleman dropped by to pick up your food order on which you could select anything you liked from a collection of local restaurant menus. The point was to keep you at your desk while the markets were open and clients were calling.

Almost everyone ordered monumentally large helpings of lunch, drinks, and snacks. It was simply hard to resist. Sitting surrounded by individual plastic containers of fresh carrots, celery sticks, strawberries, quartered kiwis and sliced peaches, nibbling the day away, you saw that someone else had ordered a container of cherries and thought “What a good idea. I'll do that tomorrow.”At 11:30 A.M. the hot food started to arrive—swordfish, steak, potatoes, rice, asparagus, whatever you wanted. To help wash it down, our food server Neil delivered six-packs of Evian or Perrier, the smallest round lot. Some people actually left for home in the late afternoon with doggy bags of food and mineral water.

I disliked the free-food perk. By noon, I had grown bloated from consuming a day's worth of food in only a few hours, and I was genuinely relieved at the loss of that privilege when QS was moved off the trading floor in mid-1990. It was easier to simply pay for what you really wanted. Later, after the fixed-income market's losses of late 1994, everyone on the trading floor had their food privileges revoked, and from then on traders, salespeople and their assistants had to go to the cafeteria or a local takeout place and buy their own food. There was an elegant VP lounge at the top of 85 Broad Street, where vice presidents could reserve sit-down formal lunches at tables bedecked with white tablecloths, waited on, for some mysterious reason, by uniformed, German-accented, middle-aged women who reminded one vaguely of Rosa Klebb. The restaurant was shut down in 1994, too, and it was high time; it harkened back to an age when being a vice president was something rare and significant. Ten years later during the dot-com boom of 2000, when casual clothing ruled, free snacks made a temporary comeback and every day each floor received Snapples, bottled water, and very fancy, presliced, Harry-and-David-style fruit. This, too, disappeared when the technology IPO market collapsed. You could see Wall Street's behavior—its manic depressive, feast-or-famine style of hiring and firing, expanding and contracting, large raises followed by large cuts—all mirrored in the waxing and waning of the food supply.

My boss was Dexter Earle, a partner at Goldman and a salesperson. This was the time in my life when I began quite unselfconsciously to refer to the person I worked for as “my boss.” My wife didn't like to hear me use the phrase; she was still in academic life and thought it a dysphemism, but I had learned over the years to regard it as merely realistic. Dexter's expertise was in portfolio rebalancing, so he didn't know that much about options and volatility, but he was willing to joke about his ignorance, smiling charmingly as though it didn't matter when, at group dinners, people occasionally roasted him by handing out blank books entitled
Dexter Earle on Derivatives
. With the confidence of graciousness, polish, silk ties, and matching suspenders, he outlasted by many years the more knowledgable but abrasive comanagers the firm brought in to assist him in running the equity derivatives business. Dexter was terrific with clients—we all used to laugh at the story of how, when Dexter was asked by a client about Goldman's approach to AI (artificial intelligence software), he parried by replying that “we are going to take a global approach and go slow.” But what impressed me most was his ability to tell when someone was misleading him about topics he didn't understand. When we listened to the occasional confident-sounding information technology fact-spinners whom I knew to be half-charlatan, the heads of trading usually bought their stories of expertise, but Dexter, a salesman himself, could identify the hollowness beneath the surface.

Dexter's secretary was a pleasantly stern woman with a penchant for odd, homeopathic remedies. The first time I went to speak to her, she made me stand impatiently at her desk for five or ten minutes while she unhurriedly filled out various administrative forms. As I waited, an old Mother Goose couplet I used to read to my children suddenly flashed through my consciousness:
I am his Majesty's dog at Kew/ Pray tell me sir, whose dog are you?
Years earlier, reading it aloud without thinking, I had thought it only a forced rhyme about a talking dog. Now, I suddenly understood it. Though I was “upstairs” and more critical to the business than she was, she was “downstairs” in a finer establishment. As years went by I learned that quants, like the little boy in A. A. Milne's poem, are always halfway down the stairs.

The new new thing in the derivatives world in 1990 was exotic options. My absorption in this world was triggered by the excitement at Goldman over what we all referred to as the “Kingdom of Denmark puts.”

On the last trading day of 1989, the Nikkei 225 index of Japanese stocks reached its zenith of 38,915.90. Throughout its ascent during what is in retrospect called the Japanese equity bubble, many Japanese companies had come to the capital markets to borrow from investors. Sometimes, in order to pay even lower interest rates, the companies had promised to eventually pay back more than they had initially borrowed, provided the Nikkei were to drop by the time the loan came due, an event to which they ascribed little probability. The greater the drop, the more yen the companies promised to repay. In options parlance, the companies had given their bondholders put options on the Nikkei, thus providing them with an insurance policy against a Nikkei decline. Some bondholders kept the bonds but sold the attached puts for cash to interested parties.

As the Nikkei ascended to ever higher levels during the late 1980s, Granny had adroitly and systematically bought large numbers of these puts that now collectively constituted a gigantic insurance policy against a decline in the Nikkei. He had bought them inexpensively, probably because the companies that issued them did not believe a sustained decline in the Nikkei was possible back in those days of soaring Tokyo property values and rising Japanese equity markets.

When I arrived in QS at the start of that year, everyone in derivatives was talking about the Kingdom of Denmark Nikkei put warrants. I heard that it was puzzled-looking Granny who had come up with the idea that Goldman issue a listed put on the Nikkei. Since we owned the inexpensive insurance against a Nikkei decline that Granny had bought, we could now sell similar protection to the public. So, in January 1990 Goldman created the Kingdom of Denmark Nikkei put warrants, struck at a Nikkei level of ¥37,516.77 with an expiration date in early 1993. They were listed on the American Stock Exchange, and the Kingdom-of-Denmark prefix referred to the issuer of the warrants, the sovereign Kingdom of Denmark to whom we paid a fee to guarantee that they would stand behind the put warrants in the event that Goldman's credit failed.

Our issuance was exquisitely timed; the Nikkei was just past its peak, and many buyers were willing to bet on its further decline. Granny had bought cheap Nikkei volatility from Japanese yen-based counterparties who didn't believe that the Nikkei would drop, and was now able to sell it to American dollar-based investors who were betting it would. Most profitable options strategies I have seen have had the same formula: Buy some simple, less attractive product wholesale, use financial engineering to transform it into something more appealing, and then sell it retail. It's a transformation that requires an understanding of clients' needs as well as technical skills.

To accomplish this, Granny added a custom-tailored, exotic subtlety to the structure of the Kingdom of Denmark Nikkei put warrants that I haven't yet mentioned. The Nikkei is an index of 225 Japanese stocks whose prices are quoted in yen. An American dollar–based investor in the Nikkei index effectively owns Japanese stocks denominated in yen, and then faces two risks: that the Nikkei drops and that the yen weakens against the dollar. American investors were happy to buy insurance against a drop in the Nikkei, of course, but they didn't want their insurance payment to decline if the yen were to simultaneously weaken as the Nikkei fell, a not unlikely occurrence. Therefore, the Kingdom of Denmark Nikkei put warrants also carried built-in protection against a drop in the yen by guaranteeing that, irrespective of what happened to the actual yen-dollar exchange rate, the payoff of the warrant would be converted to dollars at an exchange rate guaranteed in advance.

For example, if the Nikkei were to drop from 37,500 to 25,000, a drop of 12,500 index points or 33 percent, the holder of a put warrant with a face value of $1,000 and a guaranteed conversion rate of $1 per yen would receive $333, even if the yen (to take an extreme scenario) were to become worthless in dollar terms. If the conversion rate had not been guaranteed, the holder of a warrant whose payoff was converted to dollars at the prevailing exchange rate would have received no dollars at all. This was a very attractive feature for American investors, who naturally measure their profits or losses in dollars—it allowed them to profit from an overdue decline in the Japanese stock market without worrying about its effect on the yen.

The market came to refer to this feature as a “quanto” option, though I always preferred calling it a “guaranteed exchange rate” (GER) option, which seemed more apt. This was the first nonstandard or so-called exotic option I remember encountering, and like most successful structured products, its payoff reflected investors' needs.

This is where the role of financial engineering enters the picture. Even though Granny had bought yen-based puts cheaply and sold the Kingdom of Denmark puts more expensively to avid investors and speculators, there was a dangerous mismatch between their payoffs that could have eliminated our profit. The options we bought would pay us in yen if the Nikkei declined, but the Kingdom of Denmark puts we sold would oblige us to pay our counterparties in dollars. A move in the dollar-yen exchange rate could therefore diminish or even wipe out our profit. To prevent this from occurring, we would have to continually hedge the effect of any move in the dollar-yen exchange rate on the value of both the options we had bought and those we had sold.