The Quants Part 18

"I realized that the existence of the smile": My Life as a Quant My Life as a Quant, by Emanuel Derman (John Wiley & Sons, 2004), 226.

A squad of fifty armed federal marshals: Certain details come from Certain details come from Den of Thieves Den of Thieves, by James Stewart (Simon & Schuster, 1991).

He also worked as a consultant: I learned the fascinating story of Thorp's discovery of the Madoff fraud in several interviews with Thorp in December 2008 as the fraud was discovered. I confirmed his story with the firm involved and through several pertinent doc.u.ments. I learned the fascinating story of Thorp's discovery of the Madoff fraud in several interviews with Thorp in December 2008 as the fraud was discovered. I confirmed his story with the firm involved and through several pertinent doc.u.ments.

5[image] FOUR OF A KIND FOUR OF A KIND In 1990, Ed Thorp took a call: The details of Thorp's connection to Citadel was told to me by Thorp, Frank Meyer, Justin Adams, and Ken Griffin. The details of Thorp's connection to Citadel was told to me by Thorp, Frank Meyer, Justin Adams, and Ken Griffin.

Griffin set up shop: I learned a number of details about Griffin's and Citadel's history during a single interview with Griffin and numerous interviews with people who worked for him. Other details were found in the following articles: "Citadel's Griffin: Hedge Fund Superstar," by Marcia Vickers, I learned a number of details about Griffin's and Citadel's history during a single interview with Griffin and numerous interviews with people who worked for him. Other details were found in the following articles: "Citadel's Griffin: Hedge Fund Superstar," by Marcia Vickers, Fortune Fortune, April 3, 2007; "Citadel Returns 26 Percent, Breaks Hedge Fund Mold, Sees IPO," by Katherine Burton, Bloomberg News Service, April 29, 2005; "Will a Hedge Fund Become the Next Goldman Sachs?" by Jenny Anderson, New York Times New York Times, April 4, 2007.

When he was ten years old: I learned a number of details about Peter Muller's life in a series of interviews with people who knew him. Other details, such as the trip to Europe, were taken from an essay he wrote in the book I learned a number of details about Peter Muller's life in a series of interviews with people who knew him. Other details, such as the trip to Europe, were taken from an essay he wrote in the book How I Became a Quant How I Became a Quant, edited by Richard R. Lindsey and Barry Schachter (John Wiley & Sons, 2007).

The muscular professor strode: I've never attended a Fama course, but I did speak with a number of people who took his courses, including Cliff Asness, and I conducted several interviews with Fama. This is a depiction of what his course may have been like and what he may have said based on those interviews. I've never attended a Fama course, but I did speak with a number of people who took his courses, including Cliff Asness, and I conducted several interviews with Fama. This is a depiction of what his course may have been like and what he may have said based on those interviews.

As a child, Clifford Scott Asness: I learned a number of details about Asness's life in a series of interviews with Asness and people who knew him. Other details about Asness's early life were taken from an essay he wrote in the book I learned a number of details about Asness's life in a series of interviews with Asness and people who knew him. Other details about Asness's early life were taken from an essay he wrote in the book How I Became a Quant How I Became a Quant.

I conducted numerous interviews with current and former employees of AQR. Other sources include "Beta Blocker: Profile of AQR Capital Management," by Hal Lux, Inst.i.tutional Investor Inst.i.tutional Investor, May 1, 2001, and, "The Quant.i.tative, Data-Based, Risk-Ma.s.saging Road to Riches," by Joseph Nocera, New York Times Magazine New York Times Magazine, June 5, 2005.

Born near the end of the Great Depression: Fama interview. Fama interview.

Kendall found no such patterns: Quoted from Quoted from An Engine, Not a Camera: How Financial Models Shape Markets An Engine, Not a Camera: How Financial Models Shape Markets, 63.

Fama and French cranked up: The paper was called "The Cross Section of Expected Stock Returns," published in the June 1992 edition of The paper was called "The Cross Section of Expected Stock Returns," published in the June 1992 edition of Journal of Finance Journal of Finance.

One day in the early 1980s: Nearly all of the details of Boaz Weinstein's life and career come from interviews with Weinstein and people who knew and worked with him. Nearly all of the details of Boaz Weinstein's life and career come from interviews with Weinstein and people who knew and worked with him.

In 1994, John Meriwether: A number of details of LTCM's demise were taken from A number of details of LTCM's demise were taken from When Genius Failed: The Rise and Fall of Long-Term Capital Management When Genius Failed: The Rise and Fall of Long-Term Capital Management, by Roger Lowenstein (Random House, 2000), and Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It, by Nicholas Dunbar (John Wiley & Sons, 2000).

6[image] THE WOLF THE WOLF On a spring afternoon in 1985: The Liar's Poker account is taken from The Liar's Poker account is taken from The Poker Face of Wall Street The Poker Face of Wall Street, by Aaron Brown (John Wiley & Sons, 2006), as well as interviews and email exchanges with Brown.

The Culver Spy Ring sprang up: "Setauket: Spy Ring Foils the British," by Tom Morris, "Setauket: Spy Ring Foils the British," by Tom Morris, Newsday Newsday, February 22, 1998.

As a toddler growing up: Despite numerous requests, James Simons declined to grant me an interview. Details of Renaissance Technologies were learned through interviews with former employees Elwyn Berlekamp, Robert Frey, Nick Patterson, Sandor Straus, and others who asked not to be identified. Other details were found in "Simons Doesn't Say," by John Geer, Despite numerous requests, James Simons declined to grant me an interview. Details of Renaissance Technologies were learned through interviews with former employees Elwyn Berlekamp, Robert Frey, Nick Patterson, Sandor Straus, and others who asked not to be identified. Other details were found in "Simons Doesn't Say," by John Geer, Financial World Financial World, October 21, 1996, and "Simons at Renaissance Cracks Code, Doubling a.s.sets," by Richard Teitelbaum, Bloomberg News, November 27, 2007.

In December 2003, Renaissance sued: "Ex-Simons Employees Say Firm Pursued Illegal Trades," Katherine Burton and Richard Teitelbaum, Bloomberg News, June 30, 2007. "Ex-Simons Employees Say Firm Pursued Illegal Trades," Katherine Burton and Richard Teitelbaum, Bloomberg News, June 30, 2007.

7[image] THE MONEY GRID THE MONEY GRID Griffin's fortress for money: A number of details about Citadel's performance and a.s.sets were taken from Citadel offering doc.u.ments and other Citadel doc.u.ments. A number of details about Citadel's performance and a.s.sets were taken from Citadel offering doc.u.ments and other Citadel doc.u.ments.

One of Citadel's early trades: Griffin interview. Griffin interview.

Muller and Elsesser: Interviews with Kim Elsesser. Interviews with Kim Elsesser.

A founder of Prediction Company: Interviews with Doyne Farmer. Interviews with Doyne Farmer.

In 1995, a young quant named Jaipal Tuttle: Interviews with Jaipal Tuttle. Interviews with Jaipal Tuttle.

When Cliff Asness took a full-time job: Accounts of Asness's time at Goldman and the rise of AQR were taken from news articles previously listed, as well as interviews with John Liew, David Kabiller, Cliff Asness, and others who asked not to be identified. Accounts of Asness's time at Goldman and the rise of AQR were taken from news articles previously listed, as well as interviews with John Liew, David Kabiller, Cliff Asness, and others who asked not to be identified.

Black believed in rationality: Many details of Black's life derive from interviews with people who knew him, including Asness, Emanuel Derman, and others, as well as his biography, Many details of Black's life derive from interviews with people who knew him, including Asness, Emanuel Derman, and others, as well as his biography, Fischer Black and the Revolutionary Idea of Finance Fischer Black and the Revolutionary Idea of Finance, by Perry Mehrling (John Wiley & Sons, 2005).

One day Weinstein was strolling: "Young Traders Thrive in Stock, Bond Nexus," by Henny Sender, "Young Traders Thrive in Stock, Bond Nexus," by Henny Sender, Wall Street Journal Wall Street Journal, November 28, 2005.

8[image] LIVING THE DREAM LIVING THE DREAM Griffin was quietly building: Some information about Tactical Trading's performance derives from testimony in Citadel's 2009 lawsuit against Malyshev and two other ex-Citadel employees filed in the Chancery Division of Cook County, Ill., Circuit Court. Some information about Tactical Trading's performance derives from testimony in Citadel's 2009 lawsuit against Malyshev and two other ex-Citadel employees filed in the Chancery Division of Cook County, Ill., Circuit Court.

A $10 billion hedge fund called Amaranth Advisors: "How Giant Bets on Natural Gas Sank Brash Hedge-Fund Trader," by Ann Davis, "How Giant Bets on Natural Gas Sank Brash Hedge-Fund Trader," by Ann Davis, Wall Street Journal Wall Street Journal, September 19, 2006.

They also like to party: "The Birthday Party," by James B. Stewart, "The Birthday Party," by James B. Stewart, New Yorker New Yorker, February 11, 2008.

But one evening a colleague: "Going Under, Happily," by Pete Muller as told to Loch Adamson, "Going Under, Happily," by Pete Muller as told to Loch Adamson, New York Times New York Times, June 8, 2003.

In May 2002, he attended the wedding: The wedding account is based on interviews with Na.s.sim Taleb, John Liew, and Neil Chriss. The wedding account is based on interviews with Na.s.sim Taleb, John Liew, and Neil Chriss.

His peripatetic life had shown him: The brief account of Taleb's life is based on numerous interviews with Taleb and his longtime trading partner Mark Spitznagel, as well as the articles "Blowing Up: How Na.s.sim Taleb Turned the Inevitability of Disaster into an Investment Strategy," by Malcolm Gladwell, The brief account of Taleb's life is based on numerous interviews with Taleb and his longtime trading partner Mark Spitznagel, as well as the articles "Blowing Up: How Na.s.sim Taleb Turned the Inevitability of Disaster into an Investment Strategy," by Malcolm Gladwell, New Yorker New Yorker, April 22 and 29, 2002, and "Flight of the Black Swan," by Stephanie Baker-Said, Bloomberg Markets Bloomberg Markets, May 2008.

Once or twice a month: The subjects of this book did not discuss this poker game The subjects of this book did not discuss this poker game often often. A number of details were learned from people familiar with the game.

The frenzy that greeted the IPO: "Newest Hot Internet Issue Raises Question: How to Price It Fairly?" by Dunstan Prial, "Newest Hot Internet Issue Raises Question: How to Price It Fairly?" by Dunstan Prial, Wall Street Journal Wall Street Journal, November 30, 1998.

AQR's flags.h.i.+p Absolute Return Fund would gain: "The Geeks' Revenge," by Josh Friedlander, "The Geeks' Revenge," by Josh Friedlander, Absolute Return Absolute Return, July/August 2006.

One day in 2005, Boaz Weinstein: The chess match is based on several interviews with Deutsche Bank employees who witnessed the match. Weinstein corroborated the account. The chess match is based on several interviews with Deutsche Bank employees who witnessed the match. Weinstein corroborated the account.

Boaz Weinstein dealt crisply: The account of the game is based on interviews with people who attended. Some incidental details, such as Muller's victory and the amount bet, were created to add verisimilitude to the account. Muller is known to be the ace of the group, Asness the rookie. Other fund managers not named also frequently played in the game. The account of the game is based on interviews with people who attended. Some incidental details, such as Muller's victory and the amount bet, were created to add verisimilitude to the account. Muller is known to be the ace of the group, Asness the rookie. Other fund managers not named also frequently played in the game.

9[image] "I KEEP MY FINGERS CROSSED FOR THE FUTURE" "I KEEP MY FINGERS CROSSED FOR THE FUTURE"

Growing up in Seattle, Brown had: Interviews with Aaron Brown. Interviews with Aaron Brown.

Enter the credit default swap: "The $12 Trillion Idea: How Blythe Masters and the 'Morgan Mafia' Changed the World of Finance," by Gillian Tett, "The $12 Trillion Idea: How Blythe Masters and the 'Morgan Mafia' Changed the World of Finance," by Gillian Tett, FTMagazine FTMagazine, March 2526, 2006.

The first Bistro deal: "Credit Derivatives: An Overview," by David Mengle, International Swaps and Derivatives a.s.sociation, published for the 2007 Financial Markets Conference held by the Federal Reserve Bank of Atlanta, May 15, 2007. "Credit Derivatives: An Overview," by David Mengle, International Swaps and Derivatives a.s.sociation, published for the 2007 Financial Markets Conference held by the Federal Reserve Bank of Atlanta, May 15, 2007.

That solution came from a Chinese-born quant: "Slices of Risk: How a Formula Ignited Markets That Burned Some Big Investors," by Mark Whitehouse, "Slices of Risk: How a Formula Ignited Markets That Burned Some Big Investors," by Mark Whitehouse, Wall Street Journal Wall Street Journal, September 12, 2005.

Magnetar's presence in the CDO world: "A Fund Behind Astronomical Losses," by Serena Ng and Carrick Mollenkamp, "A Fund Behind Astronomical Losses," by Serena Ng and Carrick Mollenkamp, Wall Street Journal Wall Street Journal, January 14, 2008.

The carry trade was fueling: "Global Credit Ocean Dries Up," by Ambrose Evans-Pritchard, "Global Credit Ocean Dries Up," by Ambrose Evans-Pritchard, The Telegraph The Telegraph, February 28, 2006.

Regulators lent a helping hand: "Agency's '04 Rule Let Banks Pile Up New Debt," by Stephen Labaton, "Agency's '04 Rule Let Banks Pile Up New Debt," by Stephen Labaton, New York Times New York Times, October 2, 2008.

news emerged that a pair of Bear Stearns hedge funds: The Bear Stearns meltdown has been extensively covered and I used multiple sources. The best were a series of articles written by The Bear Stearns meltdown has been extensively covered and I used multiple sources. The best were a series of articles written by Wall Street Journal Wall Street Journal reporter Kate Kelly, who also wrote an excellent book doc.u.menting Bear's meltdown, reporter Kate Kelly, who also wrote an excellent book doc.u.menting Bear's meltdown, Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street (Portfolio, 2009). (Portfolio, 2009).

10[image] THE AUGUST FACTOR THE AUGUST FACTOR Cliff Asness walked to the gla.s.s part.i.tion: Virtually all of the information in this chapter derives from dozens of interviews with the partic.i.p.ants, including many who requested anonymity. A number of details of PDT's turmoil were first reported in "August Ambush: How Market Turmoil Waylaid the 'Quants,'" by Scott Patterson and Anita Raghavan, Virtually all of the information in this chapter derives from dozens of interviews with the partic.i.p.ants, including many who requested anonymity. A number of details of PDT's turmoil were first reported in "August Ambush: How Market Turmoil Waylaid the 'Quants,'" by Scott Patterson and Anita Raghavan, Wall Street Journal Wall Street Journal, September 7, 2007.

At the headquarters of Goldman Sachs: Most of the information about GSAM is based on an interview with Katinka Domotorffy, who took over Global Alpha and several other quant funds at GSAM after Mark Carhart and Raymond Iwanowski left Goldman in 2009. Most of the information about GSAM is based on an interview with Katinka Domotorffy, who took over Global Alpha and several other quant funds at GSAM after Mark Carhart and Raymond Iwanowski left Goldman in 2009.

Matthew Rothman was still groggy: Interviews with Matthew Rothman. Interviews with Matthew Rothman.

"A ma.s.sive unwind is occurring": "Behind the Stock Market's Zigzag-Stressed 'Quant' Funds Buy Shorted Stocks and Sell Their Winners," by Justin Lahart, "Behind the Stock Market's Zigzag-Stressed 'Quant' Funds Buy Shorted Stocks and Sell Their Winners," by Justin Lahart, Wall Street Journal Wall Street Journal, August 11, 2007.

"These shocks reflected one of the most": "Loosening Up: How a Panicky Day Led the Fed to Act-Freezing of Credit Drives Sudden s.h.i.+ft," by Randall Smith, Carrick Mollenkamp, Joellen Perry, and Greg Ip, "Loosening Up: How a Panicky Day Led the Fed to Act-Freezing of Credit Drives Sudden s.h.i.+ft," by Randall Smith, Carrick Mollenkamp, Joellen Perry, and Greg Ip, Wall Street Journal Wall Street Journal, August 20, 2007.

11[image] THE DOOMSDAY CLOCK THE DOOMSDAY CLOCK "We need to focus on this fast": Part of the Citadel-E*Trade deal details derive from "Why Citadel Pounced on Wounded E*Trade," by Susanne Craig, Gregory Zuckerman, and Matthew Karnitschnig, Part of the Citadel-E*Trade deal details derive from "Why Citadel Pounced on Wounded E*Trade," by Susanne Craig, Gregory Zuckerman, and Matthew Karnitschnig, Wall Street Journal Wall Street Journal, November 30, 2007.

Cliff Asness leapt from the card table: Asness's poker-playing rampage is based on accounts from people familiar with the games. As with the other poker game, some incidental details were created to add verisimilitude to the account. Asness's poker-playing rampage is based on accounts from people familiar with the games. As with the other poker game, some incidental details were created to add verisimilitude to the account.

One quant gadfly: The account is based on interviews with Na.s.sim Taleb and Aaron Brown. The account is based on interviews with Na.s.sim Taleb and Aaron Brown.

d.i.c.k Fuld was putting on a cla.s.sic performance: The account is based on an interview with a person who attended the meeting. The account is based on an interview with a person who attended the meeting.

There was a yell, a smash: The account is based on interviews with people who were present. The account is based on interviews with people who were present.

"I want to throw up": Several details of Lehman's last days, including this quote, derive from "Burning Down His House: Is Lehman CEO d.i.c.k Fuld the True Villain on the Collapse of Wall Street?" by Steve Fishman, Several details of Lehman's last days, including this quote, derive from "Burning Down His House: Is Lehman CEO d.i.c.k Fuld the True Villain on the Collapse of Wall Street?" by Steve Fishman, New York New York, December 8, 2008.

The models that gauged the risk: "Behind AIG's Fall, Risk Models Failed to Pa.s.s Real-World Test," by Carrick Mollenkamp, Serena Ng, Liam Pleven, and Randall Smith, "Behind AIG's Fall, Risk Models Failed to Pa.s.s Real-World Test," by Carrick Mollenkamp, Serena Ng, Liam Pleven, and Randall Smith, Wall Street Journal Wall Street Journal, October 31, 2008.

"That patient has had a heart attack": The account is based on an interview with New York senator Chuck Schumer. The account is based on an interview with New York senator Chuck Schumer.

12[image] A FLAW A FLAW In a May 2005 speech: "Risk Transfer and Financial Stability," by Alan Greenspan, remarks made to the Federal Reserve Bank of Chicago's Forty-first Annual Conference on Bank Structure, Chicago, Illinois, May 5, 2005. "Risk Transfer and Financial Stability," by Alan Greenspan, remarks made to the Federal Reserve Bank of Chicago's Forty-first Annual Conference on Bank Structure, Chicago, Illinois, May 5, 2005.

"Ken, you guys are getting killed": Several details of Citadel's late-2008 turmoil, and the conference, are based on an interview with Ken Griffin and interviews with numerous people familiar with the fund who requested anonymity. Others, including the James Forese quote, are based on "Citadel Under Siege: Ken Griffin's $15 billion Firm Was Flirting with Disaster This Fall," by Marcia Vickers and Roddy Boyd, Several details of Citadel's late-2008 turmoil, and the conference, are based on an interview with Ken Griffin and interviews with numerous people familiar with the fund who requested anonymity. Others, including the James Forese quote, are based on "Citadel Under Siege: Ken Griffin's $15 billion Firm Was Flirting with Disaster This Fall," by Marcia Vickers and Roddy Boyd, Fortune Fortune, December 9, 2009; and "Hedge Fund Selling Puts New Stress on Market," by Jenny Strasburg and Gregory Zuckerman, Wall Street Journal Wall Street Journal, November 7, 2008; and "A Hedge Fund King Comes Under Siege," by Jenny Strasburg and Scott Patterson, Wall Street Journal Wall Street Journal, November 20, 2009.

It was a rallying cry: Columbus did not write "Sail on" in his 1492 journal. Columbus did not write "Sail on" in his 1492 journal.

By outward appearances, Boaz Weinstein: A number of details of Saba's final days were first reported in "Deutsche Bank Fallen Trader Left Behind $1.8 Billion Hole," by Scott Patterson and Serena Ng, A number of details of Saba's final days were first reported in "Deutsche Bank Fallen Trader Left Behind $1.8 Billion Hole," by Scott Patterson and Serena Ng, Wall Street Wall Street Journal Journal, February 6, 2008.

Cliff Asness was furious: Several details of AQR's struggles in 2008 were first reported in "A Hedge-Fund King Is Forced to Regroup," by Scott Patterson, Several details of AQR's struggles in 2008 were first reported in "A Hedge-Fund King Is Forced to Regroup," by Scott Patterson, Wall Street Journal Wall Street Journal, May 23, 2009.

a fund with ties to Na.s.sim Taleb: Universa's gains were first reported in "October Pain Was 'Black Swan' Gain," by Scott Patterson, Universa's gains were first reported in "October Pain Was 'Black Swan' Gain," by Scott Patterson, Wall Street Journal Wall Street Journal, November 3, 2008.

13[image] THE DEVIL'S WORK THE DEVIL'S WORK Paul Wilmott stood before a crowded room: The account is based on firsthand reporting and interviews with Paul Wilmott. The account is based on firsthand reporting and interviews with Paul Wilmott.

Together that January, they wrote: The full "manifesto" can be found on Wilmott's website, The full "manifesto" can be found on Wilmott's website, http://www.wilmott.com/blogs/eman/index.cfm/2009/1/8/The-Financial-Modelers-Manifesto.

"They're usually doing the devil's work": Interview with Charlie Munger. Interview with Charlie Munger.

Even before the fury of the meltdown hit: The account is based on a series of interviews with Mandelbrot in his Cambridge apartment. The account is based on a series of interviews with Mandelbrot in his Cambridge apartment.

In February 2008, Ed Thorp gazed: The account is based on a meeting with Ed Thorp in his office, and a subsequent meeting with Thorp and Bill Gross in Pimco's office. The Q&A appeared in "Old Pros Size Up the Game-Thorp and Pimco's Gross Open Up on Dangers of Over-Betting, How to Play the Bond Market," by Scott Patterson, The account is based on a meeting with Ed Thorp in his office, and a subsequent meeting with Thorp and Bill Gross in Pimco's office. The Q&A appeared in "Old Pros Size Up the Game-Thorp and Pimco's Gross Open Up on Dangers of Over-Betting, How to Play the Bond Market," by Scott Patterson, Wall Street Journal Wall Street Journal, March 22, 2008.

14[image] DARK POOLS DARK POOLS On a sultry Tuesday evening: The account of the poker night is firsthand. The account of the poker night is firsthand.

Muller had been working on a new business model: "Morgan Stanley Eyes Big Trading Change," by Aaron Lucchetti and Scott Patterson, "Morgan Stanley Eyes Big Trading Change," by Aaron Lucchetti and Scott Patterson, Wall Street Journal Wall Street Journal, April 24, 2009.

There were other big changes in Simons's life: "Renaissance's Simons Delays Retirement Plans," by Jenny Strasburg and Scott Patterson, "Renaissance's Simons Delays Retirement Plans," by Jenny Strasburg and Scott Patterson, Wall Street Journal Wall Street Journal, June 11, 2009.

"They're starting to sin again": "After Off Year, Wall Street Pay Is Bouncing Back," by Louise Story, "After Off Year, Wall Street Pay Is Bouncing Back," by Louise Story, New York Times New York Times, April 26, 2009.

a new breed of stock exchange: In part derived from "Boom in 'Dark Pool' Trading Networks Is Causing Headaches on Wall Street," by Scott Patterson and Aaron Lucchetti, In part derived from "Boom in 'Dark Pool' Trading Networks Is Causing Headaches on Wall Street," by Scott Patterson and Aaron Lucchetti, Wall Street Journal Wall Street Journal, May 8, 2008.

Glossary

Arbitrage: The act of buying and selling two related securities that are priced differently with the expectation that the prices will converge. If gold costs $1,000 an ounce in New York and $1,050 in London, an arbitrageur will buy the New York gold and sell it in London. Quants use formulas to detect historical relations.h.i.+ps between a.s.sets such as stocks, currencies, and commodities, and place bets that any disruption in the relations.h.i.+ps will revert back to normal in time The act of buying and selling two related securities that are priced differently with the expectation that the prices will converge. If gold costs $1,000 an ounce in New York and $1,050 in London, an arbitrageur will buy the New York gold and sell it in London. Quants use formulas to detect historical relations.h.i.+ps between a.s.sets such as stocks, currencies, and commodities, and place bets that any disruption in the relations.h.i.+ps will revert back to normal in time (see (see statistical arbitrage) statistical arbitrage). Such bets are placed under the a.s.sumption that past performance in the market is predictive of future performance-an a.s.sumption that isn't always true.

Black-Scholes option-pricing formula: A mathematical formula that describes the price of a stock option, which is a contract that gives its owner the right to buy a stock (a call option) or sell a stock (a put option) at a certain price within a certain time. The formula has many components, one of which is the a.s.sumption that the future movement of a stock-its volatility-is random and leaves out the likelihood of large swings (see A mathematical formula that describes the price of a stock option, which is a contract that gives its owner the right to buy a stock (a call option) or sell a stock (a put option) at a certain price within a certain time. The formula has many components, one of which is the a.s.sumption that the future movement of a stock-its volatility-is random and leaves out the likelihood of large swings (see fat tails) fat tails).

Brownian motion: First described by Scottish botanist Robert Brown in 1827 when observing pollen particles suspended in water, Brownian motion is the seemingly random vibration of molecules. Mathematically, the motion is a random walk in which the future direction of the movement-left, right, up, down-is unpredictable. The average of the motion, however, can be predicted using the law of large numbers, and is visually captured by the bell curve or normal distribution. Quants use Brownian motion mathematics to predict the volatility of everything from the stock market to the risk of a multinational bank's balance sheet. First described by Scottish botanist Robert Brown in 1827 when observing pollen particles suspended in water, Brownian motion is the seemingly random vibration of molecules. Mathematically, the motion is a random walk in which the future direction of the movement-left, right, up, down-is unpredictable. The average of the motion, however, can be predicted using the law of large numbers, and is visually captured by the bell curve or normal distribution. Quants use Brownian motion mathematics to predict the volatility of everything from the stock market to the risk of a multinational bank's balance sheet.

Credit default swap: Created in the early 1990s, these contracts essentially provide insurance on a bond or a bundle of bonds. The price of the insurance fluctuates depending on the riskiness of the bonds. In the late 1990s and 2000s, more and more traders used the contracts to make bets on whether a bond would default or not. At Deutsche Bank, Boaz Weinstein was a pioneer in the use of CDS as a betting instrument. Created in the early 1990s, these contracts essentially provide insurance on a bond or a bundle of bonds. The price of the insurance fluctuates depending on the riskiness of the bonds. In the late 1990s and 2000s, more and more traders used the contracts to make bets on whether a bond would default or not. At Deutsche Bank, Boaz Weinstein was a pioneer in the use of CDS as a betting instrument.

Collateralized debt obligation: Bundles of securities, such as credit-card debt or mortgages, that are sliced up into various levels of risk, from AAA, which is deemed relatively safe, to BBB (and lower), which is highly risky. In the late 1990s, a team of quants at J. P. Morgan created "synthetic" CDOs by bundling credit default swaps linked to bonds and slicing them up into various portions of risk. In the credit meltdown of 2007 and 2008, billions in high-rated CDO and synthetic CDO slices plunged in value as borrowers defaulted on their mortgages in record numbers. Bundles of securities, such as credit-card debt or mortgages, that are sliced up into various levels of risk, from AAA, which is deemed relatively safe, to BBB (and lower), which is highly risky. In the late 1990s, a team of quants at J. P. Morgan created "synthetic" CDOs by bundling credit default swaps linked to bonds and slicing them up into various portions of risk. In the credit meltdown of 2007 and 2008, billions in high-rated CDO and synthetic CDO slices plunged in value as borrowers defaulted on their mortgages in record numbers.

Convertible bonds: Securities issued by companies that typically contain a fixed-income component that yields interest (the fixed part), as well as a "warrant," an option to convert the security into shares at some point in the future. In the 1960s, Ed Thorp devised a mathematical method to price warrants that antic.i.p.ated that Black-Scholes option-pricing formula. Securities issued by companies that typically contain a fixed-income component that yields interest (the fixed part), as well as a "warrant," an option to convert the security into shares at some point in the future. In the 1960s, Ed Thorp devised a mathematical method to price warrants that antic.i.p.ated that Black-Scholes option-pricing formula.

Efficient-market hypothesis: Based on the notion that the future movement of the market is random, the EMH claims that all information is immediately priced into the market, making it "efficient." As a result, the hypothesis states, it's not possible for investors to beat the market on a consistent basis. The chief proponent of the theory is University of Chicago finance professor Eugene Fama, who taught Cliff Asness and an army of quants who, ironically, went to Wall Street to try to beat the market in the 1990s and 2000s. Many quants used similar Fama-derived strategies that blew up in August 2007. Based on the notion that the future movement of the market is random, the EMH claims that all information is immediately priced into the market, making it "efficient." As a result, the hypothesis states, it's not possible for investors to beat the market on a consistent basis. The chief proponent of the theory is University of Chicago finance professor Eugene Fama, who taught Cliff Asness and an army of quants who, ironically, went to Wall Street to try to beat the market in the 1990s and 2000s. Many quants used similar Fama-derived strategies that blew up in August 2007.

Fat tail: The volatility of the market is typically measured using a bell curve, which represents the normal distribution of market movements captured by Brownian motion. The tails of the distribution-the left and right sides of the curve-slope downward. A fat tail represents a highly unlikely "black swan" event not captured by the bell curve, and visually is captured by a bulge on either side of the curve. Benoit Mandelbrot first devised methods to describe such extreme market events in the 1960s, but he was largely ignored. The volatility of the market is typically measured using a bell curve, which represents the normal distribution of market movements captured by Brownian motion. The tails of the distribution-the left and right sides of the curve-slope downward. A fat tail represents a highly unlikely "black swan" event not captured by the bell curve, and visually is captured by a bulge on either side of the curve. Benoit Mandelbrot first devised methods to describe such extreme market events in the 1960s, but he was largely ignored.

Gaussian copula: A model developed by financial engineer David X. Li that predicted the price correlations between various slices of collateralized debt obligations. Copulas are mathematical functions that calculate the connections between two variables-in other words, how they "copulate." When X happens (such as a homeowner defaulting), there's a Y chance that Z happens (a neighboring homeowner defaults). The specific copulas Li used were named after Carl Friedrich Gauss, the nineteenth-century German mathematician known for devising a method to measure the motion of stars through the bell curve. The connections among the default risks of the slices in a CDO were, therefore, based on the bell curve (a copula is essentially a multidimensional bell curve). In the credit crisis that began in August 2007, the model failed as the correlations between CDO slices became far tighter than expected. A model developed by financial engineer David X. Li that predicted the price correlations between various slices of collateralized debt obligations. Copulas are mathematical functions that calculate the connections between two variables-in other words, how they "copulate." When X happens (such as a homeowner defaulting), there's a Y chance that Z happens (a neighboring homeowner defaults). The specific copulas Li used were named after Carl Friedrich Gauss, the nineteenth-century German mathematician known for devising a method to measure the motion of stars through the bell curve. The connections among the default risks of the slices in a CDO were, therefore, based on the bell curve (a copula is essentially a multidimensional bell curve). In the credit crisis that began in August 2007, the model failed as the correlations between CDO slices became far tighter than expected.

Hedge fund: Investment vehicle that is open only to wealthy individuals or inst.i.tutions such as pension funds and endowments. Hedge funds tend to use copious amounts of leverage, or borrowed money, and charge high fees, typically 2 percent of a.s.sets under management and 20 percent or more of profits. One of the first hedge funds was launched in 1949 by Alfred Winslow Jones, a reporter, who "hedged" positions by taking offsetting long and short positions in various stocks. Ed Thorp started a hedge fund in 1969 named Convertible Hedge a.s.sociates, later changed to Princeton/Newport Partners. Investment vehicle that is open only to wealthy individuals or inst.i.tutions such as pension funds and endowments. Hedge funds tend to use copious amounts of leverage, or borrowed money, and charge high fees, typically 2 percent of a.s.sets under management and 20 percent or more of profits. One of the first hedge funds was launched in 1949 by Alfred Winslow Jones, a reporter, who "hedged" positions by taking offsetting long and short positions in various stocks. Ed Thorp started a hedge fund in 1969 named Convertible Hedge a.s.sociates, later changed to Princeton/Newport Partners.

Law of large numbers: The law states that the more observations one makes, the greater the certainty of prediction. Ten coin flips could produce 70 percent heads and 30 percent tails. Ten thousand coin flips are far more likely to approach 50 percent heads and 50 percent tails. Thorp used the LLN to win at blackjack and went on to use it on Wall Street. Many quant formulas are based on it. The law states that the more observations one makes, the greater the certainty of prediction. Ten coin flips could produce 70 percent heads and 30 percent tails. Ten thousand coin flips are far more likely to approach 50 percent heads and 50 percent tails. Thorp used the LLN to win at blackjack and went on to use it on Wall Street. Many quant formulas are based on it.

Statistical arbitrage: A trading strategy in which computers track the relations.h.i.+ps between hundreds or thousands of stocks and implement trades based on those relations.h.i.+ps. The computers look for periods when the long-term relations.h.i.+p breaks down and makes bets that the relations.h.i.+p will revert back. The strategy was first deployed by a computer programmer, Gerry Bamberger, at Morgan Stanley in the 1980s. It quickly became one of the most powerful and popular trading methods ever devised, helping launch the giant New York hedge fund D. E. Shaw and others. Peter Muller at Morgan Stanley's Process Driven Trading was one of the most adept stat arb traders. The strategy imploded in the quant crisis of August 2007. A trading strategy in which computers track the relations.h.i.+ps between hundreds or thousands of stocks and implement trades based on those relations.h.i.+ps. The computers look for periods when the long-term relations.h.i.+p breaks down and makes bets that the relations.h.i.+p will revert back. The strategy was first deployed by a computer programmer, Gerry Bamberger, at Morgan Stanley in the 1980s. It quickly became one of the most powerful and popular trading methods ever devised, helping launch the giant New York hedge fund D. E. Shaw and others. Peter Muller at Morgan Stanley's Process Driven Trading was one of the most adept stat arb traders. The strategy imploded in the quant crisis of August 2007.

Acknowledgments

A cast of thousands, it seems, helped me with this book, including a mult.i.tude of unnamed sources behind the scenes who explained the inner workings of these highly secretive investors. My agent, Shawn Coyne, helped bring the idea to life and deserves enormous credit for helping develop it. My editor, Rick Horgan, and his gifted a.s.sociate editor, Julian Pavia, had a wealth of ideas that gave a healthy kickstart to the book when it needed it. Mitch Zuckoff was an ideal sounding board and provided fantastic insights into how to put the book together and make the ideas understandable. Thanks to my editors at The Wall Street Journal The Wall Street Journal, particularly Jon Hilsenrath and Nik Deogun, who encouraged my interest in writing about this strange group of traders; and Anita Raghavan, who helped me crack open the quant group at Morgan Stanley. A virtual army of traders and professors helped me better understand the world of the quants, including Mark Spitznagel, Na.s.sim Taleb, Paul Wilmott, Emanuel Derman, Aaron Brown, Benoit Mandelbrot, and so many others. Ed Thorp devoted far too much time to help me understand the true nature of trading and risk management, as well as his own amazing career. As promised, I'd like to thank ANONYMOUS. Mostly, I thank my wife, Eleanor, whose understanding, patience, and constant encouragement over the past few years made this book possible.