Jim Gatheral spent 17 years at Merrill Lynch in equity derivatives trading before joining the Baruch MFE program faculty full-time in 2010. He is the best-selling author of The Volatility Surface: A Practitioner's Guide. As someone who hired quants at Merrill Lynch and has been teaching in the NYU Math Finance program since its inception, Gatheral talks to quantnet.com about his career, the challenges facing aspiring quant students and the fast changing landscape of global financial market.
Can you give us a recap on your education background and career?
My undergraduate degree was in Mathematics and Natural Philosophy at the University of Glasgow. My PhD was in Theoretical Physics at Cambridge University and my thesis title "Infrared Divergences in Perturbative QCD". I joined Bank of America in London as a trainee loan officer in 1983 with the title of Assistant Cashier, receiving my first bonus of £400 in 1985. I started trading currency options at BofA in 1984 and subsequently joined Bankers Trust to trade interest rate derivatives in 1986. I ended up running currency options and then ran Capital Markets (effectively derivatives trading) in Tokyo in the early 1990s. I joined Merrill Lynch in 1993 as global head of equity derivatives trading and set up the quant team in 1996, retiring from the firm earlier this year.
How did you end up in finance?
Some investment bank whose name I cannot recall approached me when I was still an undergraduate and so I got the idea that banking might appeal to me even before i embarked on my PhD. When it was time to look for a post-doc position, for many reasons, I decided that i would have more fun in finance than in theoretical physics. And even from my current vantage point, it seems to me that my decision was correct.
What do you consider as your accomplishments up to this point?
I think it's hard to talk in terms of accomplishments in business. If I hadn't done this or that deal first, somebody else would have. In other words, one doesn't usually build anything of lasting value. If I were forced, I would say that at Bankers Trust, I was involved in many firsts including the first lookback option deal and the first Asian option deal (well if not the first then at least one of the first). And at Merrill Lynch I put together a good quant team which played a major role in our leadership in various market segments such as convertible bonds and the variance swap business when it started booming in the late nineties. In terms of academic accomplishments, I am happy to have been part of the NYU masters program since its inception and even happier with the recognition that my lectures on the volatility surface and my subsequent book received. The biggest compliment I got was when a student told me "you helped me sound smart at my interview".
If you have a chance to start your career anew, what would you like to do differently knowing what you know now? Would it still be in finance or some other field?
If I had a chance to start over, I would listen better and concentrate more. As for whether my career would be in finance or some other field, I think that the answer to this question is a function of circumstances; In 2010, as in 1983, we have just witnessed a major crisis of capitalism, one of the many crises that capitalism has survived. I just read a piece by an economist who said that the recent performance of economics was so bad because all the smart economists had gone into finance. In the future, i hope that we will see some kind of reallocation of resources so that smart people can find the same kind of financial and intellectual rewards in other fields as are currently on offer in the world of finance. However, if I were graduating now, I would want to be in finance because that's still where the money and brains are.
You recently joined Baruch College as a tenured professor in their Math Dept after seventeen years as MD at Merrill Lynch. Tell us the main reasons for you to leave Wall Street?
Who says I left Wall Street? I still have many friends there and I expect to continue to be involved in some fashion. As for why I became an academic, it's primarily a question of personal and intellectual freedom. I can decide how to spend my time and be more or less my own boss. If I decide to travel somewhere or spend a day at the museum, nobody cares. And I can write and speak free of commercial considerations. That said, I still have to turn up to teach and my lectures better be good.
What do you miss most about your time on Wall Street?
If there is one thing that I do miss, it's the fun of running a trading book and the energy of the trading room. But I am looking forward to concentrating on teaching and research - you can't really do these and trade at the same time!
What would you say contributed to your successful career as a quantitative finance professional?
Luck was of course a huge element in my success but as they say, luck favors the prepared. I think in my case, my willingness to act with less than perfect information along with a willingness to communicate openly with others were significant contributors to my success. And I do think that I have a certain skill in communicating complex ideas.
Why did you choose to join the faculty of Baruch MFE program instead of other big name programs?
They wanted me! Kidding apart, the department is small and friendly, the students are good and it's a mathematics department as opposed to a business school. So there will be more opportunity for me to teach and study the kinds of things I like. And of course the department has good mathematicians from whom I can learn. I guess I should mention the purpose-built trading floor that we can use for trading simulations and last but not least, Dan Stefanica is very persuasive to say the least!
Besides teaching and doing research, what other projects/initiatives you’d like to spearhead in the next few years for the Baruch MFE program?
I think that teaching and research are enough don't you? However, as part of that, I think we may see participation in some wider initiatives such as the new Initiative for the Theoretical Sciences at the CUNY Graduate Center and the existing monthly New York Quantitative Finance Seminar.
If you have a chance to rewrite/update your book after the last credit crisis, what would you change?
I don't think that the credit crisis as such would have caused me to change anything; equity derivatives models did fine during the crisis. I wish the book were better written but then as my friend Bruno Dupire famously wrote in the blurb, I couldn't have written a better book. There is a lot missing in the book: hedging, model calibration and multiple timescale modeling to name just a few topics that are not really covered at all.
Your research has recently moved into Market Microstructure. Tell us what is significant about this area that captures your interest?
What is really interesting about this area is that nothing is yet well understood, and the timing is perfect because we now have access to huge amounts of high frequency data. Obviously, with my physics background, I am particularly interested in the recent developments in econophysics. From the theoretical point of view, I think we are closer than ever to a good understanding of the process of price formation and from the practical point of view, simple physics-style models have already led to the development of more efficient algorithms that minimize transaction costs.
How do you connect Market Microstructure to Algo trading?
The way I like to define things, market microstructure is the theory underlying algorithm construction. That said, most algorithms are even now constructed without any theory - there is still a huge opportunity for quants to get involved.
What would be the area in quant finance that will experience most innovative research idea and product growth in the next few years?
If you will forgive me for talking my own book on this one, I think that the answers are market microstructure and volatility surface dyanamics. More specifically, there is likely to be less emphasis on exotic derivatives in my view and more trading will take place on exchanges. This means in particular that we won't need models to compute the prices of financial derivatives because pricing will be transparent. And if there is less inventory on dealer books, that means that options dealers will need to better understand and model the shapes and dynamics of volatility surfaces, just as option market makers attempt to do today. Up to now, models have been largely normative: We come up with some plausible process, derive some pricing formula, and fit the resulting model to market prices. In the future, models will have to have realistic dynamics, consistent with observation. Control of execution costs will also be critical and for that, a good understanding of market microstructure will be essential.
What would you advise people who want a career as a financial engineer?
My advice to such people is the same as my advice to anyone embarking on any career: Keep studying and learning, keep up with the latest research and find people to work with who will teach you something.
Where do you see a growth for people with quantitative background?
Obviously, my background is finance and I do think that there will be continued and increasing demand for people with quantitative backgrounds. I can foresee a time when it will be more or less impossible to get a trading job without a graduate qualification such as Baruch's Masters in Financial Engineering.
Many have an unrealistic expectation or idealism of what a quant do, mostly from movies and books like “Wall Street”, “My Life as a Quant”, “Liar's Poker”. What would you tell them?
I agree that, to me at least, "Wall Street" was not very realistic but both “My Life as a Quant” and “Liar’s Poker” were pretty realistic I thought. I take the attitude that most disappointments of this sort are not related to actual differences between expectation and reality but more to the individual's view of reality. I always insisted to the quants that they ran the business and I meant it: Changing a model changes the way traders behave - something that is very hard to achieve as a trading manager. An alternative view might have been that these same quants were just producing models on trader request. There is some truth in both views but the first point of view is life-affirming, reinforcing the quant's view of his own responsibility to the firm. The second point of view, taken to an extreme, absolves the quant of any such responsibility. One can easily see how two quants faced with the same reality can have very different levels of career satisfaction.
You have been involved with teaching and hiring many graduates of MFE programs, first at NYU and now at Baruch MFE, and in your role at Merrill Lynch. What do you think about the curriculum of these programs, the quality of the graduates and what would you like to change about it?
Different programs have developed different personalities and there are many good programs. I would like to see more graduates develop more intuition for models and markets before they join companies.
Many students have viewed MFE programs as a quick pathway to a “get rich quick” job on Wall Street. In fact, the number of universities opening up this type of programs has increased the past decade. This leads to a wide quality disparity among people coming out of these programs. What would you advise aspiring students who plan to join these MFE programs?
I would advise students to pay careful attention to the content of a masters program. The prestige that comes from being admitted to one of the top schools will get you through the first year or two but not necessarily further. A masters program offers the student a golden opportunity to build a solid basis for his future career; course content and quality of teaching are crucial.
What would be the essential skill/knowledge every financial engineer should have?
Every financial engineer, in addition to what is taught in a typical masters course, should be able to communicate effectively with non-specialists and should have a basic understanding of business and financial accounting.
What other job options should one look at outside of Wall Street where quantitative skills are appreciated?
I'm no expert. But based on the people I have seen hired as quants, bio-engineering and computational genomics are two areas in which highly quantitative graduates can find rewarding employment outside the financial industry.
SEC has charged Goldman Sachs with defrauding their investors in one of the CDO deals. What would be your comments?
It's not at all clear that the SEC will be successful in their case against Goldman Sachs. After all, which sophisticated investor thinks that the security that is being recommended to them is not being shorted by somebody else. Moreover, Goldman's case seems to be that the client was told that this particular CDO was being shorted by Paulson. Nevertheless, Goldman Sachs is already guilty in the court of public opinion and this helps to prepare the ground for much tougher regulation of investment banking.
With the government stepping up effort to regulate Wall Street, are the days of “innovative financial products” over or will we see Wall Street remake itself to adapt to a stricter environment?
I think we will continue to see innovation in financial markets but pricing will be much more transparent than in the past with more trading taking place on exchanges and certainly much improved reporting of transactions.
Much has been said about “quant” in the media the past two years. Where do you think these financial engineers play a role in the credit crisis? What lessons can we learn going forward?
I don't think that quants are to blame for the crisis but nor are they blameless. Many quants knew that credit models were seriously flawed yet how many of them spoke out clearly? Chuck Prince of Citigroup has been pilloried for saying "as long as the music is playing, you've got to get up and dance" yet all he was doing was to elegantly (and perhaps unwisely) articulate what everyone including quants knew, which is that to be in the game, you have to play the game. Some quant lessons to be learned are that model risk needs to be estimated and that it is crucial to model the underlying dynamics as faithfully as possible.
What do you think about the financial reform bill in its current form? Will the Volcker’s rule hurt or help Wall Street business and ultimately the economic recovery?
As far as I understand it, nobody knows what reform will precisely entail except that we now know who will be responsible for regulating various aspects of the financial markets. The Volcker rule will obviously not help Wall Street business nor can it help financial recovery; the aim of the rule (whose execution is yet to be defined) is to lessen the probability that taxpayers will have to once more bail out a financial firm in the future. Everyone understands I think that in order to reduce systemic risk in this way, we have to pay a price; the price will be reduced efficiency and reduced profits. That said, efficiency and profits are not ends in themselves - society has a right and a duty to regulate financial markets in my view. And increased regulation will definitely come - but who knows what good regulation should look like?
Quantnet recently reported that Robert Merton has rejoined MIT to teach in their MFin program. What do you think about the current collaboration between academia and industry when it comes to research on financial engineering? How can this relationship be improved to benefit both sides?
In my view, collaboration between academia and industry in financial mathematics and engineering has always been good and over time, this collaboration has only got better. One can even identify a number of practitioners who are really more like academics and a number of academics who are really more like practitioners. Industry obviously directly benefits from academic research through implementation of the latest ideas and techniques. Academics benefit from this relationship by getting constant inspiration for new (and relevant) research. The short answer to your question is that I don't think that the relationship between industry and academia needs to be improved.
What are your favorite books? Movies? TV shows? Music?
I like reading history, I love the Almodóvar movies, I like watching Anthony Bourdain on TV and I enjoy playing piano and listening to classical music.
What is something about you that most people don’t know?
I sincerely hope that most things about me people don't know.
What other projects are you involved in?
Teaching and research are my only projects - other activities are just hobbies.
What would you imagine yourself doing 10 years from now.
Teaching, research, looking after students...
Thank you for your time, Dr. Gatheral.