Tuesday, May 25, 2010

Book Review: The Quants

The Quants by Scott Patterson

In The Quants, Patterson provides an intriguing account of Wall Street's most successful quantitative analysts (aka quants) and the role they played in the subprime crisis.

The first few chapters introduce the main players and provide a brief introduction to quantitative finance. Patterson begins by describing how Ed Thorp applied his mathematics background and experience pioneering Black Jack card counting techniques to invent various hedging techniques and start the first arbitrage hedge fund. From there, Patterson lightly introduces other important concepts like Brownian Motion, Random Walk Theory, Efficient Market Hypothesis, and statistical arbitrage. The introduction winds down with the October, 1987 market crash which is used as the context to introduce the "fat tail" contrary point of view personified by Benoit Mandelbrot, and Nassim Nicholas Taleb - a not so subtle foreshadow.

The "middle" of the book discusses the background, career, and substantial success of primarily five high-profile quants: Pete Muller, Ken Griffin, Cliff Asness, Boaz Weinstein, and Jim Simmons. Other Wall Street personalities are also mentioned but to a lesser extent. This part of the book more or less establishes that the above quants are very smart, and very rich.

The last part of the book provides a blow-by-blow account of the sub-prime crisis. All of the quants appeared to be caught off guard, perplexed by the market's "irrational" behavior, and unshure of how to adjust their models to prevent further losses. Throughout the ordeal, many of the quants are forced to question the very foundations of their mathematical models and prior success - was it all just luck?

Over all, I thought this book was OK but felt it tried to cover too much ground as a quantitative finance primer, homage to quants, historical account of the sub-prime crisis, and financial mystery-thriller. Since my interest lies more in the technical details, I was a disappointed with those portions of the book and uninterested in the dramatized historical account. Perhaps I simply had the wrong expectations of the book.

It's also possible that my expectations were set artificially high by Poundstone's excellent book Fortune's Formula which provides a detailed historical and technical account of the events that gave rise to the quantitative finance industry. If you're interested in this topic, then I highly recommend Fortune's Formula.

While reviewing the book to write this review, one passage caught my eye on page 250 regarding a study performed by MIT Professor Andrew Lo and his student Amir Khandani:

There was also the worry about what happened if high-frequency quant funds, which had become a central cog of the market, helping transfer risk at lightning speeds, were forced to shut down by extreme volatility. "Hedge funds can decide to withdraw liquidity at a moment's notice," they wrote, "and while this may be benign if it occurs rarely and randomly, a coordinated withdrawal of liquidity among an entire sector of hedge funds could have a disastrous consequences for the viability of the financial system if it occurs at the wrong time and in the wrong sector."

There is some evidence indicating that the withdrawal of high-frequency liquidity was a contributing factor to the May 6, 2010 flash crash. I doubt the story of the quants is over just yet.