From Physics to Finance

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From Physics to Finance

• Piotr Karasinski
• Global Head of Quantitative Development, HSBC
• Email piotr.karasinski_at_hsbcib.com

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Physics versus Finance

• Physics
• We believe in the existence of universal eternal
  fundamental laws, written in the language of
  mathematics, that can explain the physical world.
• Finance
• Past performance is not a guarantee of future
  performance
• Models create markets and shape the way market
  participants think and act. Their use influences
  market behaviour.
• According to George Soross reflexivity theory
  peoples biases and actions can affect the
  direction of the underlying economy.

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How I ended up on Wall street?
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How I Got into Finance

• In late May 1984, while in my last year of
  physics PhD studies at Yale, I ran into a Yale
  physics friend, wearing the traditional
  graduation gown and accompanied by his whole
  family. He worked somewhere in New York and came
  to Yale to attend his PhD graduation.
• I said Tom, could you help me find a job in New
  York. Would you like to trade gold options?
  he replied. I knew what gold was, had no idea
  what the word option meant but was desperate to
  get a job, any job! Having nothing to lose I
  immediately exclaimed I would love to.
• Tom called me a week later saying that his boss,
  head of trading at commodity trading firm Mocatta
  Metals, was looking to hire somebody like me. I
  went to NY a couple of days later for an
  interview and got hired. Toms boss had an
  applied math PhD from Courant Institute. Mocatta
  Metals was run by its founder Yale psychiatry
  professor Henry Jarecki.
• I knew nothing about finance, let alone about
  option pricing (the term derivatives did not
  exist in 1984). I learned the whole field on the
  job by working on projects and through my own
  readings. What made a big difference was that
  in April 1987 I moved to Goldman Sachs where I
  was hired by Fischer Black. I got the interview
  through a Mocatta Metals friend who knew a member
  of Fischers quant team.

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Why Physics?

• Reading Biography of Physics by George Gamov
  was the tipping point. I was particularly taken
  by the human drama behind the process of
  discovery. I found this book on the for-sale
  shelf, selling for something like 10 cents, in a
  scientific book store in Warsaw.
• Fascination with the idea that you can discover
  the ultimate laws of nature doing table-top
  experiments and capture the results through
  mathematics lead me to study physics at Warsaw
  University followed by doctoral studies at Yale.
  

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Why Finance?

• I found in finance what I was looking for in
  physics the ability to combine intellectual
  thought and practical action. I enjoy the
  interdisciplinary nature of the practice of
  finance in a global bank.
• The desire for commercial success might be in my
  DNA. My father ran his own small manufacturing
  business in Warsaw so I grew up with, and was
  fascinated by, the commercial side of life.

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a few words of wisdom
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What You Need for Business Success

• Quote from Kenneth D. Brody, co-founder of
  Taconic Capital Advisors, former Goldman Sachs
  partner. Ken received a BS in EE from the
  University of Maryland and a MBA from the Harvard
  Business School.
•  
• Good judgment regarding human behaviour is more
  important than intelligence in achieving business
  success"

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Good Sense in Seeking Truth in the Sciences

• Quote from "Discourse on the Method of Rightly
  Conducting the Reason, and Seeking Truth in the
  Sciences by Rene Descartes
• Good sense is, of all things among men, the most
  equally distributed for every one thinks himself
  so abundantly provided with it, that those even
  who are the most difficult to satisfy in
  everything else, do not usually desire a larger
  measure of this quality than they already
  possess. And in this it is not likely that all
  are mistaken the conviction is rather to be held
  as testifying that the power of judging aright
  and of distinguishing truth from error, which is
  properly what is called good sense or reason, is
  by nature equal in all men and that the
  diversity of our opinions, consequently, does not
  arise from some being endowed with a larger share
  of reason than others, but solely from this, that
  we conduct our thoughts along different ways, and
  do not fix our attention on the same objects.
  For to be possessed of a vigorous mind is not
  enough the prime requisite is rightly to apply
  it. The greatest minds, as they are capable of
  the highest excellences, are open likewise to the
  greatest aberrations and those who travel very
  slowly may yet make far greater progress,
  provided they keep always to the straight road,
  than those who, while they run, forsake it.

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Advice from Freeman Dyson

• The following piece of wisdom from Freeman Dyson
  is highly relevant when moving from maths/physics
  into finance.
• I gazed at the stars as a young boy, he once
  wrote. Thats what science means to me. Its not
  theories about stars its the actual stars that
  count.

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Moving to finance key facts
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Jobs in Finance

• Business
• Trader
• Structurer/Marketer
• Strategist
• Quant/IT
• Quant in a front-office group
• Quant developer
• Quant in a control function model validation,
  product control, market/credit risk management
• Software developer

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Types of Derivative Financial Products

• Underlying asset equity, interest rate, foreign
  currency, commodity, credit, cross-asset (hybrid)
• Linear products futures, forwards, swaps
  (interest rate, equity, )
• Nonlinear products vanilla/plain options, exotic
  options
• Market place exchange traded, OTC
  (over-the-counter)

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What Do Quants Do?

• Implement derivatives pricing models
• Develop tools for calibrating model parameters
• Analyse model performance
• Provide day-to-day trading desk support

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What We Are Looking For?

• People who enjoy solving problems that involve
  finance, maths, computation and software
  development in an interdisciplinary dynamic
  environment.
• People with keen interest in finance demonstrated
  through own reading, specialized coursework, etc.
• Skills/Qualities
• Common sense
• High level of energy and enthusiasm
• Communication/interpersonal
• Ability to work in a team environment
• Maths (with special emphasis on probability and
  stochastics)
• Computing
• Programming C, C, Java, VBA/EXCEL, Matlab,
  Splus/R

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Computational Techniques

• Direct numerical integration, linear algebra
  (eigensystems)
• Root-finding, linear and non-linear least-square
  fitting, function minimization
• Monte-Carlo quasi-random (Sobol points),
  pseudo-random (Marsenne Twister)
• PDEs
• Crank-Nicholson in one dimension
• ADI in two and three dimensions (Crank-Nicholson
  for each dimension)
• Up/Down winding
• Various techniques for dealing with
  discontinuities (Rannacher time-stepping, etc.)
• Smoothing boundary conditions
• Fast Fourier and Laplace transforms
• Numerical libraries NAG, IMSL, GSL (Gnu
  Scientific Library), etc.

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Probability/Statistics and Stochastics

• Probability/Statistics
• One and multi dimensional normal distribution
  need to know inside-out
• Poisson distribution
• Concepts mean/median value, variance/covariance,
  skew, kurtosis, leptokurtic (fat-tailed),
  biased/unbiased estimator, sampling distribution
  for an estimator, Fisher transformation applied
  to correlation estimation
• Stochastics
• Markov chains
• Poisson processes
• Wiener process, arithmetic and geometric Brownian
  motions
• Gaussian mean-reverting, Ornstein-Uhlenbeck,
  process and its properties
• Kolmogorov forward (Fokker-Planck)/backward
  equation
• Stochastic calculus Itos lemma, Girsanovs
  theorem
• Monte-Carlo simulation of stochastic processes
  (start with Ornstein-Uhlenbeck)
• Concepts mean-reversion, auto/cross-correlation,
  drift, volatility, stochastic volatility,
  estimation of volatilities/correlations

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Basic Finance Knowledge

• Basic facts about stocks, bonds, call/put
  options, interest rates, inflation
• Stocks dividend yield, price volatilities, P/E
  ratios
• Bonds coupon rate, yield-to-maturity
• Forwards and futures
• Call/put options strike, expiry, implied
  volatility, option delta/gamma/vega
• Interest rates
• time value of money
• compounding of interest
• short-rate (continuously compounded instantaneous
  interest rate)
• interbank rate (LIBOR), yields on government and
  corporate bonds with standard maturities
  (typically 5 and 10 years), interest rate swap
  rates
• real and nominal rate, inflation

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Models to Read About

• CAPM Capital Asset Pricing Model as it led Black
  and Scholes to their option pricing model
• Black-Scholes model
• Derive the Black-Scholes PDE using Ito lemma and
  riskless hedge argument
• Gaussian Mean-Reverting Short-Rate model (also
  known under Vasicek and Hull-White names)

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Books, magazines and articles
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Books

• General Interest
• Emanuel Derman, My Life as a Quant
  Reflections on Physics and Finance
• Perry Mehrling, Fischer Black and the
  Revolutionary Idea of Finance
• Robert E. Rubin In an Uncertain World
  Tough Choices from Wall Street to Washington
• Barry Schachter and Richard R. Lindsey How I
  Became a Quant
• Lisa Endlich Goldman Sachs The
  Culture of Success
•  
•  Preparing for a quant job interview
• Paul Wilmott Frequently Asked Questions in
  Quantitative Finance
• Timothy Crack Heard on the Street Quantitative
  Questions from Wall Street Job Interviews
• Technical Quant Books
•  
• Paul Miron and Philip Swannell Pricing and
  Hedging Swaps
• John C. Hull Options, Futures and Other
  Derivatives
• Paul Glasserman Monte-Carlo Methods in Financial
  Engineering
• Steven E. Shreve Stochastic Calculus for
  Finance

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Books (continued)

• Economics Financial Markets Books
•  
• Robert Shiller Irrational Exuberance
• William Silber Principles of Money,
  Banking, and Financial Markets
• Other 
• Freeman Dyson The Scientist as Rebel
• Robert Solomon, Kathleen Higgins, A Short
  History of Philosophy
• Daniel Goleman Emotional Intelligence
• Roger Fisher Getting to Yes Negotiating
  Agreement Without Giving In
• Eric Berne Games People Play The
  Psychology of Human Relationships
• Robert Greene The 48 Laws of Power, The
  33 Strategies of War
• Elizabeth Kuhnke Body Language for Dummies
• William Zinsser On Writing Well,
  Writing to Learn
•  

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Articles and Magazines

• Articles
• RISK Books, www.riskbooks.com, publishes
  collections of articles
• March 9, 2006, The Wall Street Journal Proving
  Ground Why Students of Prof. El Karoui Are in
  Demand (see www.ermii.org/News/Article_NEK_WSJ1.
  pdf)
• www.ssrnc.com has lots of interesting quant
  papers
• www.defaultrisk.com is the webs biggest credit
  risk modelling resource
•  
• Magazines
• Risk
  www.risk.net
• Financial Analyst Journal
  www.cfapubs.org/loi/faj?cookieSet1
• Wilmott
  www.wilmott.com