Podcast Summary
Globalization of finance led to increased demand for exotic equity derivatives: The fall of the Berlin Wall sparked interest in foreign investments, leading investors to use derivatives for simpler global exposure and pension funds to bypass restrictions.
The globalization of finance after the Cold War played a significant role in the explosion of exotic equity derivatives. As Emanuel Derman explained in his book "My Life as a Quant," after the Berlin Wall came down, people became interested in investing in foreign stock markets but didn't want to buy individual stocks. Instead, they used options, which were simpler and allowed for exposure to various indices around the world. Additionally, some pension funds, like those in Canada, were restricted from buying large amounts of foreign stock and opted for derivatives instead. This trend towards investing globally through derivatives is an important reminder of the interconnectedness of financial markets and how events on a global scale can shape the financial landscape.
Exotic options: Customized financial derivatives: Exotic options provide investors with more tailored market exposure, allowing them to hedge specific risks and make bets using complex financial instruments, while banks effectively manage their risk using models like the Black-Scholes.
Exotic options are a type of financial derivative that provide more customized exposure to various markets compared to standard options. They gained importance in the international financial scene due to their ability to help investors hedge against specific risks, such as currency risk, while making speculative bets. For instance, the Nikkei put options issued by Goldman Sachs in the 1980s were exotic because they allowed investors to bet on the Nikkei index going down without facing currency risk. These options were "exotic" because they were more complex than standard options, requiring banks to hedge their risk effectively. Banks used the Black-Scholes model and its extensions to price and hedge these exotic options, which involved synthesizing them from the underlying assets. This way, investors could fine-tune their risk, while banks could manage theirs effectively.
Industrial Revolution in Quantitative Finance in the 1980s: The 1980s marked an industrial revolution in quantitative finance, with the explosion of exotic options and need for risk management leading to globalization, new financial products, and academic research.
Quantitative finance in the 1980s underwent an industrial revolution of sorts, marked by the explosion of exotic options and the need to manage associated risks. As a physicist turned financier, the speaker joined Goldman Sachs in 1985, working on extending the Black Scholes model for pricing options on bonds. This period was characterized by globalization and the ability to trade foreign markets, leading to an efflorescence of new financial products and academic papers. The speaker's role involved decomposing complex financial instruments into simpler constituents, acting as a middleman or market maker. This process was likened to creating a fruit salad, where one must understand the cost of production and add a spread for risk. The speaker's earlier work focused on pricing options on bonds, which required a different model due to bonds' finite life. Overall, this era saw significant growth in the financial industry due to the evolution of products and risk management methods. The speaker expressed excitement about the transition from academia to Wall Street, as it presented new challenges and opportunities in valuing and hedging innovative financial instruments.
From academia to Wall Street: Finding value in different worlds: A physicist turned financier shares his experience of balancing research and commercial application in the unique environment of Wall Street, emphasizing the importance of finding value in diverse fields and the potential for synergy between academia and business.
The world of academia and the business world can have different perspectives and values, but both can be interesting and valuable. The speaker, a physicist turned financier, shares his experience of feeling ashamed for leaving the "monastery" of physics research to work in a corporation. He felt that those who pursued practical applications were looked down upon, but learned that everything is interesting if you look closely. When he worked on Wall Street, he faced the challenge of balancing proprietary information with public research, but found that educating clients led to better business. He emphasizes that it was a rare environment where research and commercial application could coexist, and that building software to manage risk was their real job. While the culture has shifted since then, the speaker's experience highlights the importance of finding value in various fields and the potential for synergy between academia and business.
1987 stock market crash changed how options were priced: The 1987 stock market crash led to an increase in demand for put options and their prices, as investors recognized the potential for significant market downturns and slow recoveries.
The 1987 stock market crash marked a significant shift in the financial market landscape, leading to a change in how options were priced. Before the crash, the Black Scholes model was widely used to price options, assuming the same risk for different strikes. However, after the market dropped dramatically in 1987, investors realized that markets tend to crash down significantly but recover slowly. As a result, the demand for put options (which profit when the market drops) increased, and their prices rose accordingly. This change in market behavior has remained ever since, even affecting other markets like gold. The recent Brexit referendum sell-off serves as a reminder of the potential risks associated with systematic traders, who may react mechanically to market downturns and create a feedback loop. While these traders have done well in recent months, their actions could potentially impact the markets they're trying to model, making it crucial to remain adaptive and agile in financial markets.
Models have limitations, especially during market shifts: Models may not accurately reflect rare events or new market regimes, emphasizing the importance of adaptability and skepticism towards overreliance on models
Models used in finance, while useful, have limitations and may not accurately reflect market behavior during significant shifts or new regimes. The speaker mentioned the example of negative interest rates, which were not accounted for in previous models, requiring new models and adjustments. He also noted the criticism that models may not accurately capture rare events, or 10 sigma events. The financial industry is constantly evolving, with trends like deglobalization and a shift away from exotic options towards job market skills. The speaker expressed his skepticism towards the idea of writing down an equation that accurately reflects human behavior, emphasizing the importance of recognizing the limitations of models and adapting to new market conditions.
Finance industry shifts towards programming skills: The finance industry is evolving, requiring strong programming skills due to algorithmic and high frequency trading, regulatory requirements. Some see it as a loss of Wall Street's culture, others as necessary adaptation.
The job market in finance has shifted towards requiring strong programming skills and away from the exoticism of Wall Street. This trend, which has been ongoing for the past 5-6 years, is driven by algorithmic trading, high frequency trading, and regulatory requirements. While some may view this as a loss of the informal and exciting culture of the past, others see it as a necessary adaptation to the changing financial landscape. The speaker, who has worked in finance for many years, expresses a sense of sadness about the loss of the collaborative and experimental atmosphere of his past experiences, but acknowledges that regulation may be necessary up to a point. He is currently working on a textbook about the volatility smile and has an interest in the anthropology of finance, exploring how traders use models that they know are wrong but continue to use effectively.
Understanding Finance Through Metaphors of Surfing and Skateboarding: People have been fascinated by volatility as an asset since the 1970s, drawing parallels to physical activities like surfing and skateboarding. While finance involves hedging against risk and focusing on ups and downs, it's important to remember its human roots and the real-world implications of financial models.
The world of finance and financial engineering, particularly in relation to volatility and options, can be understood through metaphors drawn from physical activities like surfing and skateboarding. These activities involve hedging against risk and focusing on the ups and downs, much like in finance. Emmanuel German, an author in the field, argues that people have been interested in volatility as an asset since the 1970s, and this interest can be seen as akin to wandering city streets and experiencing excitement. However, it's important to remember that finance is a real-world field, not a branch of mathematics, and its models are not always perfect. The history of finance can be traced from personal driven business to the rise of mathematics and software, and understanding this evolution requires recognizing the human behavior underlying these changes. Despite the mathematical complexities, the practical use and potential pitfalls of these models are crucial to consider.
Unexpected market events happening more frequently: Financial models struggle to predict rare market events, which are occurring more often, and investors and professionals need to stay informed and adapt
Despite advancements in financial modeling, unexpected market events continue to occur more frequently than predicted. These events, which are statistically rare, seem to be happening more often, and current models are not well-equipped to account for this trend. This was highlighted during the recent market fallout from Brexit and other VAR shocks. It's important for investors and financial professionals to stay informed and adapt to these changing market conditions. Additionally, we wanted to share some exciting news with our listeners. Our friend and colleague, Matt Levine, who writes the popular Bloomberg Opinion Money Stuff newsletter, is starting a new podcast with Katie Greifelt. The podcast, also called Money Stuff, will air every Friday and will delve deeper into the finance and business stories that Matt covers in his newsletter. Listeners can tune in on Apple Podcasts, Spotify, or wherever they get their podcasts. Stay tuned for more information on this new podcast, and as always, we'll be here next week with another edition of Odd Lots.
