Quantitative analysis (finance) - thesis

This thesis written by Craig Guerra

Quantitative analysis is the use of mathematical and statistical methods in finance and
investment management. Those working in the field are quantitative analysts. Quants tend to
specialize in specific areas which may include derivative structuring or pricing, risk management,
algorithmic trading and investment management. The occupation is similar to those in industrial
mathematics in other industries. The process usually consists of searching vast databases for
patterns, such as correlations among liquid assets or price-movement patterns. The resulting
strategies may involve high-frequency trading.
Although the original quantitative analysts were "sell side quants" from market maker firms,
concerned with derivatives pricing and risk management, the meaning of the term has
expanded over time to include those individuals involved in almost any application of
mathematical finance, including the buy side. Applied quantitative analysis is commonly
associated with quantitative investment management which includes a variety of methods such
as statistical arbitrage, algorithmic trading and electronic trading.
Some of the larger investment managers using quantitative analysis include Renaissance
Technologies, D. E. Shaw & Co., and AQR Capital Management.
History
Quantitative finance started in 1900 with Louis Bachelier's doctoral thesis "Theory of
Speculation", which provided a model to price options under a normal distribution. Harry
Markowitz's 1952 doctoral thesis "Portfolio Selection" and its published version was one of the
first efforts in economics journals to formally adapt mathematical concepts to finance.
Markowitz formalized a notion of mean return and covariances for common stocks which
allowed him to quantify the concept of "diversification" in a market. He showed how to
compute the mean return and variance for a given portfolio and argued that investors should
hold only those portfolios whose variance is minimal among all portfolios with a given mean
return. Although the language of finance now involves Itô calculus, management of risk in a
quantifiable manner underlies much of the modern theory.
Modern quantitative investment management was first introduced from the research of Edward
Thorp, a mathematics professor at New Mexico State University and University of California,
Irvine. Considered the "Father of Quantitative Investing", He was able to create a system, known
broadly as card counting, which used probability theory and statistical analysis to successfully
win blackjack games. In 1969 Robert Merton promoted continuous stochastic calculus and
continuous-time processes. Merton was motivated by the desire to understand how prices are
set in financial markets, which is the classical economics question of "equilibrium", and in later
papers he used the machinery of stochastic calculus to begin investigation of this issue. At the
same time as Merton's work and with Merton's assistance, Fischer Black and Myron Scholes
developed the Black–Scholes model, which was awarded the 1997 Nobel Memorial Prize in
Economic Sciences. It provided a solution for a practical problem, that of finding a fair price for a
European call option, i.e., the right to buy one share of a given stock at a specified price and
time. Such options are frequently purchased by investors as a risk-hedging device.
In 1981, Harrison and Pliska used the general theory of continuous-time stochastic processes to
put the Black–Scholes model on a solid theoretical basis, and showed how to price numerous
other derivative securities. The various short-rate models, and the more general HJM
Framework, relatedly allowed for an extension to fixed income and interest rate derivatives.
Similarly, and in parallel, models were developed for various other underpinnings and
applications, including credit derivatives, exotic derivatives, real options, and employee stock
options. Quants are thus involved in pricing and hedging a wide range of securities – asset-
backed, government, and corporate – additional to classic derivatives; see contingent claim
analysis.
Emanuel Derman's 2004 book My Life as a Quant helped to both make the role of a quantitative
analyst better known outside of finance, and to popularize the abbreviation "quant" for a
quantitative analyst.
After the financial crisis of 2007–2008, considerations re counterparty credit risk were
incorporated into the modelling, previously performed in an entirely "risk neutral world",
entailing three major developments; see :
Option pricing and hedging inhere the relevant volatility surface and banks then apply "surface
aware" local- or stochastic volatility models;
The risk neutral value is adjusted for the impact of counter-party credit risk via a credit valuation
adjustment, or CVA, as well as various of the other XVA;
For discounting, the OIS curve is used for the "risk free rate", as opposed to LIBOR as previously,
and, relatedly, quants must model under a "multi-curve framework"
.
Education
Quantitative analysts often come from financial mathematics, financial engineering, applied
mathematics, physics or engineering backgrounds, and quantitative analysis is a major source of
employment for people with financial mathematics master's degrees, or with mathematics and
physics PhD degrees.
Typically, a quantitative analyst will also need extensive skills in computer programming, most
commonly C, C++, Java, R, MATLAB, Mathematica, and Python.
Data science and machine learning analysis and modelling methods are being increasingly
employed in portfolio performance and portfolio risk modelling, and as such data science and
machine learning Master's graduates are also hired as quantitative analysts.
This demand for quantitative analysts has led to the creation of specialized Masters and PhD
courses in financial engineering, mathematical finance, computational finance, and/or financial
reinsurance. In particular, Master's degrees in mathematical finance, financial engineering,
operations research, computational statistics, applied mathematics, machine learning, and
financial analysis are becoming more popular with students and with employers. See Master of
Quantitative Finance for general discussion.
This has in parallel led to a resurgence in demand for actuarial qualifications, as well as
commercial certifications such as the CQF.
The more general Master of Finance increasingly includes a significant technical component.
Types
Front office quantitative analyst
In sales and trading, quantitative analysts work to determine prices, manage risk, and identify
profitable opportunities. Historically this was a distinct activity from trading but the boundary
between a desk quantitative analyst and a quantitative trader is increasingly blurred, and it is
now difficult to enter trading as a profession without at least some quantitative analysis
education. In the field of algorithmic trading it has reached the point where there is little
meaningful difference. Front office work favours a higher speed to quality ratio, with a greater
emphasis on solutions to specific problems than detailed modeling. FOQs typically are
significantly better paid than those in back office, risk, and model validation. Although highly
skilled analysts, FOQs frequently lack software engineering experience or formal training, and
bound by time constraints and business pressures, tactical solutions are often adopted.
See also structurer.
Quantitative investment management

Quantitative analysis is used extensively by asset managers. Some, such as FQ, AQR or Barclays,
rely almost exclusively on quantitative strategies while others, such as PIMCO, Blackrock or
Citadel use a mix of quantitative and fundamental methods.
One of the first quantitative investment funds to launch was based in Santa Fe, New Mexico and
began trading in 1991 under the name Prediction Company. By the late-1990s, Prediction
Company began using statistical arbitrage to secure investment returns, along with three other
funds at the time, Renaissance Technologies and D. E. Shaw & Co, both based in New York.
Library quantitative analysis
Major firms invest large sums in an attempt to produce standard methods of evaluating prices
and risk. These differ from front office tools in that Excel is very rare, with most development
being in C++, though Java, C# and Python are sometimes used in non-performance critical tasks.
LQs spend more time modeling ensuring the analytics are both efficient and correct, though
there is tension between LQs and FOQs on the validity of their results. LQs are required to
understand techniques such as Monte Carlo methods and finite difference methods, as well as
the nature of the products being modeled.
Algorithmic trading quantitative analyst
Often the highest paid form of Quant, ATQs make use of methods taken from signal processing,
game theory, gambling Kelly criterion, market microstructure, econometrics, and time series
analysis. Algorithmic trading includes statistical arbitrage, but includes techniques largely based
upon speed of response, to the extent that some ATQs modify hardware and Linux kernels to
achieve ultra low latency.
Risk management
This area has grown in importance in recent years, as the credit crisis exposed holes in the
mechanisms used to ensure that positions were correctly hedged; see FRTB,.
A core technique continues to be value at risk
- applying both the parametric and "Historical" approaches, as well as Conditional value at risk
and Extreme value theory -
while this is supplemented with various forms of stress test, expected shortfall methodologies,
economic capital analysis, direct analysis of the positions at the desk level,
and, as below, assessment of the models used by the bank's various divisions.
Innovation
In the aftermath of the financial crisis, there surfaced the recognition that quantitative valuation
methods were generally too narrow in their approach. An agreed upon fix adopted by numerous
financial institutions has been to improve collaboration.
Model validation
Model validation takes the models and methods developed by front office, library, and modeling
quantitative analysts and determines their validity and correctness; see model risk.
The MV group might well be seen as a superset of the quantitative operations in a financial
institution, since it must deal with new and advanced models and trading techniques from
across the firm.
Post crisis, regulators now typically talk directly to the quants in the middle office - such as the
model validators - and since profits highly depend on the regulatory infrastructure, model
validation has gained in weight and importance with respect to the quants in the front office.
Before the crisis however, the pay structure in all firms was such that MV groups struggle to
attract and retain adequate staff, often with talented quantitative analysts leaving at the first
opportunity.
This gravely impacted corporate ability to manage model risk, or to ensure that the positions
being held were correctly valued.
An MV quantitative analyst would typically earn a fraction of quantitative analysts in other
groups with similar length of experience. In the years following the crisis, as mentioned, this has
changed.
Quantitative developer
Quantitative developers, sometimes called quantitative software engineers, or quantitative
engineers, are computer specialists that assist, implement and maintain the quantitative
models. They tend to be highly specialised language technicians that bridge the gap between
software engineers and quantitative analysts. The term is also sometimes used outside the
finance industry to refer to those working at the intersection of software engineering and
quantitative research.
Mathematical and statistical approaches
Because of their backgrounds, quantitative analysts draw from various forms of mathematics:
statistics and probability, calculus centered around partial differential equations, linear algebra,
discrete mathematics, and econometrics. Some on the buy side may use machine learning. The
majority of quantitative analysts have received little formal education in mainstream economics,
and often apply a mindset drawn from the physical sciences. Quants use mathematical skills
learned from diverse fields such as computer science, physics and engineering. These skills
include advanced statistics, linear algebra and partial differential equations as well as solutions
to these based upon numerical analysis.
Commonly used numerical methods are:
Finite difference method – used to solve partial differential equations;
Monte Carlo method – Also used to solve partial differential equations, but Monte Carlo
simulation is also common in risk management;
Ordinary least squares – used to estimate parameters in statistical regression analysis;
Spline interpolation – used to interpolate values from spot and forward interest rates curves,
and volatility smiles;
Bisection, Newton, and Secant methods – used to find the roots, maxima and minima of
functions
Techniques
A typical problem for a mathematically oriented quantitative analyst would be to develop a
model for pricing, hedging, and risk-managing a complex derivative product. These quantitative
analysts tend to rely more on numerical analysis than statistics and econometrics. One of the
principal mathematical tools of quantitative finance is stochastic calculus. The mindset,
however, is to prefer a deterministically "correct" answer, as once there is agreement on input
values and market variable dynamics, there is only one correct price for any given security.
A typical problem for a statistically oriented quantitative analyst would be to develop a model
for deciding which stocks are relatively expensive and which stocks are relatively cheap. The
model might include a company's book value to price ratio, its trailing earnings to price ratio,
and other accounting factors. An investment manager might implement this analysis by buying
the underpriced stocks, selling the overpriced stocks, or both. Statistically oriented quantitative
analysts tend to have more of a reliance on statistics and econometrics, and less of a reliance on
sophisticated numerical techniques and object-oriented programming. These quantitative
analysts tend to be of the psychology that enjoys trying to find the best approach to modeling
data, and can accept that there is no "right answer" until time has passed and we can
retrospectively see how the model performed. Both types of quantitative analysts demand a
strong knowledge of sophisticated mathematics and computer programming proficiency.
Academic and technical field journals
Society for Industrial and Applied Mathematics Journal on Financial Mathematics
The Journal of Portfolio Management
Quantitative Finance
Risk Magazine
Wilmott Magazine
Finance and Stochastics
Mathematical Finance
Areas of work
Trading strategy development
Portfolio management and Portfolio optimization
Derivatives pricing and hedging: involves software development, advanced numerical
techniques, and stochastic calculus.
Risk management: involves a lot of time series analysis, calibration, and backtesting.
Credit analysis
Asset and liability management
Structured finance and securitization
Asset pricing
Seminal publications
1900 – Louis Bachelier, Théorie de la spéculation
1938 – Frederick Macaulay, The Movements of Interest Rates. Bond Yields and Stock Prices in
the United States since 1856, pp. 44–53, Bond duration
1944 – Kiyosi Itô, "Stochastic Integral", Proceedings of the Imperial Academy, 20, pp. 519–524
1952 – Harry Markowitz, Portfolio Selection, Modern portfolio theory
1956 – John Kelly, A New Interpretation of Information Rate
1958 – Franco Modigliani and Merton Miller, The Cost of Capital, Corporation Finance and the
Theory of Investment, Modigliani–Miller theorem and Corporate finance
1964 – William F. Sharpe, Capital asset prices: A theory of market equilibrium under conditions
of risk, Capital asset pricing model
1965 – John Lintner, The Valuation of Risk Assets and the Selection of Risky Investments in Stock
Portfolios and Capital Budgets, Capital asset pricing model
1967 – Edward O. Thorp and Sheen Kassouf, Beat the Market
1972 – Eugene Fama and Merton Miller, Theory of Finance
1972 – Martin L. Leibowitz and Sydney Homer, Inside the Yield Book, Fixed income analysis
1973 – Fischer Black and Myron Scholes, The Pricing of Options and Corporate Liabilities and
Robert C. Merton, Theory of Rational Option Pricing, Black–Scholes
1976 – Fischer Black, The pricing of commodity contracts, Black model
1977 – Phelim Boyle, Options: A Monte Carlo Approach, Monte Carlo methods for option pricing
1977 – Oldřich Vašíček, An equilibrium characterisation of the term structure, Vasicek model
1979 – John Carrington Cox; Stephen Ross; Mark Rubinstein, Option pricing: A simplified
approach, Binomial options pricing model and Lattice model
1980 – Lawrence G. McMillan, Options as a Strategic Investment
1982 – Barr Rosenberg and Andrew Rudd, Factor-Related and Specific Returns of Common
Stocks: Serial Correlation and Market Inefficiency, Journal of Finance, May 1982 V. 37: #2
1982 – Robert Engle, Autoregressive Conditional Heteroskedasticity With Estimates of the
Variance of U.K. Inflation, Seminal paper in ARCH family of models GARCH
1985 – John C. Cox, Jonathan E. Ingersoll and Stephen Ross, A theory of the term structure of
interest rates, Cox–Ingersoll–Ross model
1987 – Giovanni Barone-Adesi and Robert Whaley, Efficient analytic approximation of American
option values. Journal of Finance. 42 : 301–20. Barone-Adesi and Whaley method for pricing
American options.
1987 – David Heath, Robert A. Jarrow, and Andrew Morton Bond pricing and the term structure
of interest rates: a new methodology, Heath–Jarrow–Morton framework for interest rates
1990 – Fischer Black, Emanuel Derman and William Toy, A One-Factor Model of Interest Rates
and Its Application to Treasury Bond, Black–Derman–Toy model
1990 – John Hull and Alan White, "Pricing interest-rate derivative securities", The Review of
Financial Studies, Vol 3, No. 4 Hull-White model
1991 – Ioannis Karatzas & Steven E. Shreve. Brownian motion and stochastic calculus.
1992 – Fischer Black and Robert Litterman: Global Portfolio Optimization, Financial Analysts
Journal, September 1992, pp. 28–43 Black–Litterman model
1994 – J.P. Morgan RiskMetrics Group,, 1996, RiskMetrics model and framework
2002 – Patrick Hagan, Deep Kumar, Andrew Lesniewski, Diana Woodward, Managing Smile Risk,
Wilmott Magazine, January 2002, SABR volatility model.
2004 – Emanuel Derman, My Life as a Quant: Reflections on Physics and Finance
See also
List of quantitative analysts
Financial modeling
Black–Scholes equation
Financial signal processing
Financial analyst
Technical analysis
Fundamental analysis
Financial economics
Mathematical finance
Alpha generation platform
References
Further reading
Bernstein, Peter L. Capital Ideas: The Improbable Origins of Modern Wall Street
Bernstein, Peter L. Capital Ideas Evolving
Derman, Emanuel My Life as a Quant
Patterson, Scott D.. The Quants: How a New Breed of Math Whizzes Conquered Wall Street and
Nearly Destroyed It. Crown Business, 352 pages.. via on Fresh Air, Feb. 1, 2010, including excerpt
"Chapter 2: The Godfather: Ed Thorp". Also, from "Chapter 10: The August Factor", in the
January 23, 2010 Wall Street Journal.
Read, Colin Rise of the Quants
External links
http://sqa-us.org – Society of Quantitative Analysts
http://www.q-group.org/ — Q-Group Institute for Quantitative Research in Finance
http://cqa.org – CQA—Chicago Quantitative Alliance
http://qwafafew.org/ – QWAFAFEW – Quantitative Work Alliance for Finance Education and
Wisdom
http://prmia.org – PRMIA—Professional Risk Managers Industry Association
http://iaqf.org – International Association of Quantitative Finance
http://www.lqg.org.uk/ – London Quant Group
http://quant.stackexchange.com – question and answer site for quantitative finance