The Physics of Wall Street: a brief History of Predicting the Unpredictable

Physics Hits the Street 
•
123
change. Beginning with the carter administration in the late 1970s, the 
U.S. economy entered a period of high inflation and low growth that 
has subsequently been dubbed “stagflation.” In response, Paul volcker, 
the chairman of the federal reserve from 1979 through 1987, increased 
interest rates dramatically, so that the prime interest rate, the rate that 
determines how expensive it is for banks to lend to one another —
and, by extension, to lend to consumers — reached an unprecedented 
level of 21.5%. volcker was successful at reducing inflation, which he 
had under control by 1983. But this volatility in interest rates forever 
changed the previously sleepy bond industry. If banks couldn’t borrow 
from one another for less than 20%, surely corporations and govern-
ments that were trying to issue bonds would need to pay even higher 
rates (since typically bonds are more risky than interbank loans). the 
so-called bond bores of the 1970s, traders who had chosen to work in 
the least exciting of the financial markets, now needed to cope with the 
most variable market of all. (Sherman Mccoy, the star-crossed anti-
hero of thomas Wolf’s novel Bonfire of the Vanities, was an eighties-era 
bond trader who took himself to be so important, given the changes 
in the bond markets during the late seventies and early eighties, that 
he privately called himself a “Master of the Universe.” the name has 
stuck, now used to refer to Wall Street traders of all stripes.)
the success of the Black-Scholes model and other derivatives mod-
els during the 1970s inspired some economists to ask whether bonds 
could be modeled in a similar way to options. Soon, Black and oth-
ers had realized that bonds themselves could be thought of as simple 
derivatives, with interest rates as the underlying asset. they began to 
develop modified versions of the Black-Scholes model to price bonds, 
based on the hypothesis that interest rates undergo a random walk.
thus, Black arrived on Wall Street at a moment when derivatives, 
and derivative models, were proving increasingly important, in unex-
pected ways. Black’s Quantitative Strategies Group at Goldman Sachs, 
as well as similar groups at other major banks, provided an answer to 
questions that many investment bankers, and especially bond traders, 
hadn’t known how to ask. At the same time, there was a large pool of 
underemployed physicists who were ready to step in and follow Black’s 
lead in changing financial practice. once a few physicists and half-

---

physicists had made their way to Wall Street, and once the usefulness 
of the ideas that Black had managed to translate from theory to prac-
tice was appreciated, the floodgates opened. Wall Street began hiring 
physicists by the hundreds.
derman stayed at Bell Labs for five years. Starting in 1983, though, 
he began to get phone calls from headhunters sent from investment 
banks. He was unhappy enough at Bell Labs that he took these offers 
seriously, but when he finally received an offer from Goldman Sachs, 
he declined it on the advice of an acquaintance who had worked there 
before. But the world was changing. derman found the next year at 
Bell Labs intolerable, and so when Wall Street came calling again, in 
1985, he was ready to move. He decided to go with Goldman Sachs 
after all, and in december of 1985 he made the leap. His job was in the 
financial Services Group, which supported Goldman’s bond traders. 
By the time he arrived, Black was already an institutional legend.
Both thorp and Black based their options models on osborne’s ran-
dom walk hypothesis, which amounted to assuming that rates of re-
turn are normally distributed. this might give you pause. After all, 
Mandelbrot argued throughout the 1960s that normal and log-nor-
mal distributions do not effectively account for extreme events, that 
markets are wildly random. even if Mandelbrot’s claim that rates of 
return are Lévy-stable distributed and thus do not have well-defined 
volatility is false — and most economists now believe it is — the weaker 
claim that market data exhibit fat tails still holds. options models as-
sign prices based on the probability that a stock will rise above (or 
drop below) a certain threshold — namely, the strike price for the op-
tion. If extreme market changes are more likely than osborne’s model 
predicts, neither thorp’s model nor the Black-Scholes model will get 
options prices right. In particular, they should undervalue options that 
would be exercised only if the market makes a dramatic move, so-
called far-out-of-the-money options. A more realistic options model, 
meanwhile, should account for fat tails.
Mandelbrot left finance at the end of the 1960s, but he returned in 
the early 1990s. one of the reasons was that many financial practi-
tioners were beginning to recognize the shortcomings of the Black-
124 
•
t h e p h y s i c s o f wa l l s t r e e t

---