Date posted: February 17, 2008

Waves, Codes and Derivatives

“You lose a sense of the amounts when you’re doing this kind of job,” Jerome Kerviel, the rogue trader who lost French bank Société Générale nearly € 5 billion, told Agence France-Presse in an interview, Tuesday 5 February. “It is dematerialized. You can get carried away.”

«On perd la notion des montants quand on est engagé dans ce genre de métier. C'est dématérialisé. On se laisse un peu emporter».

It reminded me of a passage in Underworld, the brilliant novel by Don DeLillo, “I sometimes wonder what money is,” she said. “Yes, of course, exactly. I will tell you what I think. It is becoming very esoteric. All waves and codes. A higher kind of intelligence. Travels at the speed of light.”

I also refer to this passage in The Fisher Account. When you’re working with quantitative models of derivatives or look at the graph of a timeseries the underlying reality can fade into the background. But you should never forget that at the end of the day you’re dealing with real money, not numbers, equations or second order moments and that your model is just a stylized representation of the data.

I’ve always found that there is a certain ethereal beauty to quantitative finance. In a way it is as real and abstract as dance. The bodies of the dancers are real but the movements, no matter how gestural, are always abstract, because they have been stripped from their practical goal in daily life and are only performed to create artistic or entertainment value. Derivatives can be used to hedge against risk, but they can also be used to speculate, in which case they have to be hedged themselves (which Jerome Kerviel didn’t do).

With variance futures and volatility swaps you get a direct exposure to pure variance (or volatility) without exposure to the direction of movements in the underlying asset. You are exposed to movement itself or in itself. (I’m not sure how to put this in proper Hegelian terms, it’s been a while since I studied Hegel). Isn’t that great? What’s more, you can engage in cross index volatility arbitrage and trade your view of the level of realized volatility versus implied volatility!

Finance is also an area that doesn’t put a limit to creativity and imagination. These days if you’re looking for a mind-boggling read you’d do better to pick up a copy of the Financial Times than your average novel. Even I hadn’t heard of some of the products and markets that are currently in the news. I think this is true for many other financial markets professionals as well. I must say that I left quantitative finance some years ago and my experience is in equity derivatives and not so much in credit derivatives and structured finance.

Law firm Thacher Proffitt (what’s in a name) has compiled a glossary of common terms in structured finance. The opening line: “Structured finance is an art as well as an integral component of the global capital markets as we know them today.”