Fama and French cranked up: The paper was called “The Cross Section of Expected Stock Returns,” published in the June 1992 edition of 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.
In 1994, John Meriwether: A number of details of LTCM’s demise were taken from 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, by Nicholas Dunbar (John Wiley & Sons, 2000).
6 THE WOLF
On a spring afternoon in 1985: The Liar’s Poker account is taken from 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, 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, Financial World, October 21, 1996, and “Simons at Renaissance Cracks Code, Doubling Assets,” 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.
7 THE MONEY GRID
Griffin’s fortress for money: A number of details about Citadel’s performance and assets were taken from Citadel offering documents and other Citadel documents.
One of Citadel’s early trades: Griffin interview.
Muller and Elsesser: Interviews with Kim Elsesser.
A founder of Prediction Company: Interviews with Doyne Farmer.
In 1995, a young quant named 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.
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, 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, Wall Street Journal, November 28, 2005.
8 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.
A $10 billion hedge fund called Amaranth Advisors: “How Giant Bets on Natural Gas Sank Brash Hedge-Fund Trader,” by Ann Davis, Wall Street Journal, September 19, 2006.
They also like to party: “The Birthday Party,” by James B. Stewart, New Yorker, February 11, 2008.
But one evening a colleague: “Going Under, Happily,” by Pete Muller as told to Loch Adamson, New York Times, June 8, 2003.
In May 2002, he attended the wedding: The wedding account is based on interviews with Nassim 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 Nassim Taleb Turned the Inevitability of Disaster into an Investment Strategy,” by Malcolm Gladwell, New Yorker, April 22 and 29, 2002, and “Flight of the Black Swan,” by Stephanie Baker-Said, Bloomberg Markets, May 2008.
Once or twice a month: The subjects of this book did not discuss this poker game 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, Wall Street Journal, November 30, 1998.
AQR’s flagship Absolute Return Fund would gain: “The Geeks’ Revenge,” by Josh Friedlander, 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.
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.
9 “I KEEP MY FINGERS CROSSED FOR THE FUTURE”
Growing up in Seattle, Brown had: 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, FTMagazine, March 25–26, 2006.
The first Bistro deal: “Credit Derivatives: An Overview,” by David Mengle, International Swaps and Derivatives Association, 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, Wall Street Journal, September 12, 2005.
Magnetar’s presence in the CDO world: “A Fund Behind Astronomical Losses,” by Serena Ng and Carrick Mollenkamp, Wall Street Journal, January 14, 2008.
The carry trade was fueling: “Global Credit Ocean Dries Up,” by Ambrose Evans-Pritchard, The Telegraph, February 28, 2006.
Regulators lent a helping hand: “Agency’s ’04 Rule Let Banks Pile Up New Debt,” by Stephen Labaton, 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 Wall Street Journal reporter Kate Kelly, who also wrote an excellent book documenting Bear’s meltdown, Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street (Portfolio, 2009).
10 THE AUGUST FACTOR
Cliff Asness walked to the glass partition: Virtually all of the information in this chapter derives from dozens of interviews with the participants, 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, 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.
Matthew Rothman was still groggy: Interviews with Matthew Rothman.
“A massive unwind is occurring”: “Behind the Stock Market’s Zigzag—Stressed ‘Quant’ Funds Buy Shorted Stocks and Sell Their Winners,” by Justin Lahart, 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 Shift,” by Randall Smith, Carrick Mollenkamp, Joellen Perry, and Greg Ip, Wall Street Journal, August 20, 2007.
11 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, Wall Street Journal, November 30, 2007.
Cliff Asness leapt from the card table: Asness’s poker-playing rampage is based on accounts from people familia
r 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 Nassim Taleb and Aaron Brown.
Dick Fuld was putting on a classic performance: 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.
“I want to throw up”: Several details of Lehman’s last days, including this quote, derive from “Burning Down His House: Is Lehman CEO Dick Fuld the True Villain on the Collapse of Wall Street?” by Steve Fishman, New York, December 8, 2008.
The models that gauged the risk: “Behind AIG’s Fall, Risk Models Failed to Pass Real-World Test,” by Carrick Mollenkamp, Serena Ng, Liam Pleven, and Randall Smith, 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.
12 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.
“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, Fortune, December 9, 2009; and “Hedge Fund Selling Puts New Stress on Market,” by Jenny Strasburg and Gregory Zuckerman, Wall Street Journal, November 7, 2008; and “A Hedge Fund King Comes Under Siege,” by Jenny Strasburg and Scott Patterson, Wall Street Journal, November 20, 2009.
It was a rallying cry: 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, Wall Street 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, Wall Street Journal, May 23, 2009.
a fund with ties to Nassim Taleb: Universa’s gains were first reported in “October Pain Was ‘Black Swan’ Gain,” by Scott Patterson, Wall Street Journal, November 3, 2008.
13 THE DEVIL’S WORK
Paul Wilmott stood before a crowded room: 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, 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.
Even before the fury of the meltdown hit: 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, Wall Street Journal, March 22, 2008.
14 DARK POOLS
On a sultry Tuesday evening: 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, 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, Wall Street Journal, June 11, 2009.
“They’re starting to sin again”: “After Off Year, Wall Street Pay Is Bouncing Back,” by Louise Story, 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, 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 relationships between assets such as stocks, currencies, and commodities, and place bets that any disruption in the relationships will revert back to normal in time (see statistical arbitrage). Such bets are placed under the assumption that past performance in the market is predictive of future performance—an assumption 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 assumption that the future movement of a stock—its volatility—is random and leaves out the likelihood of large swings (see 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.
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.
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.
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 anticipated 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.
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 downwa
rd. 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.
Hedge fund: Investment vehicle that is open only to wealthy individuals or institutions 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 assets 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 Associates, 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 Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It Page 36