Empirical Evidence of a Physics-Finance Career Transition

1. Empirical Evidence of a Physics-Finance Career Transition From theoretical physics at UCSB to financial engineering on Wall St. Joseph L. D’Anna, PhD, CFA Director Financial Engineering, SG Constellation Société Générale Corporate and Investment Bank January 21, 2005

2. Presentation Agenda • What’s a physicist doing on Wall St.? • One finance career trajectory • Representative Project • Making the transition • Contacts, books, sites etc.

3. What’s a physicist doing on Wall St.? …and what is a “Quant”

4. Who hires physicists for finance jobs? There are many companies and positions that can provide a successful transition point from physics to finance • Commercial and Investment Banks: analysts, desk quants, risk managers, auditors, developers, traders • Many firms that provide services to financial institutions require analysts with advanced technical skills and occasionally hire physicists. • Financial Software Companies • Bond Rating Agencies • Accounting Firms • Management Consulting Firms • Insurance Companies, Hedge Funds, Asset Managers • Generally will have fewer opportunities for the inexperienced than banks but are worth pursuing

5. “Traditional” Wall St. Jobs for “Quants” • Risk Manager or Auditor • Most institutions hire physicists to review models and develop and monitor risk • Affords exposure to many areas of the finance and many opportunities to network • Considered “Back Office” job and can be tougher to transition from to “Front Office” than Desk Quant • “Desk Quant” • Support a trading desk or business unit (“Front Office”) by developing or customizing software, conducting statistical studies, updating inputs to quantitative trading systems, etc. • Generally requires C++ programming skill, long hours, little glory • Analysis, software development aspects can exist individually in specialized jobs for PhD quants in third party companies like Software Companies, Rating Agencies, Accounting Firms, Consulting Firms • Can lead to junior trading, or financial engineering opportunities • Trader • Manages portfolios of securities and derivatives for institutions • Common strategies often involve complex combinations of transactions, and real-time adjustments to investments based on numerous, rapidly changing observable prices. • Requires intelligent, resourceful, decisive people that can operate under pressure • Financial Engineer/Structurer • Generally “sits” between Traders and Salespersons • Invents and manages construction of client solutions for sales thus creating risks in trading book • Develops permanent risk transfer solutions for existing risks in trading book • Conducts quantitative analysis to support internal (management) and external (client) decision making processes

6. Job Markets for “Quants” • New York • Has a very deep job market with many opportunities for inexperienced • Chicago • Many fewer opportunities than New York and dwindling • Most are related to commodities trading by institutions and hedge funds • London, Tokyo, … • Attractive pay/benefits and interesting positions • Require prior experience • Job’s exist for “quants” in other cities but Job Market’s do not • Many bank and insurance company headquarters are far flung places…though many of those still house their capital markets arms in New York • e.g. Bank of America is based in Charlotte NC (formerly San Francisco) but much of its trading operation is in NYC

7. Financial Engineering at a Wall St. Investment Bank Plus • High intensity, project oriented work • Professionals respect and rely on your skills as critical to complex businesses • Interesting and important mathematical research possible • High pay directly linked to performance, good benefits and perks Minus • Long hours, high pressure to perform • Barriers to entry for some jobs, danger of being pigeonholed • Less security than some fields • Bureaucratic frustrations and mgmt. prejudices • Research must often be on own-time (see “long hours”) • Geographic locations of best jobs limited

8. Financial Engineeringcan require coordination of design, analysis, approval, and explanation of transactions across numerous regimes • Legal considerations related to derivatives, corporate finance, bankruptcy, tax • State, Federal, Foreign Country jurisdictions can each apply separately • Interaction with internal, external and client legal representation required. • Often different firms for different jurisdictions. • Government Regulators • Banks, brokers, and insurance companies all have numerous regulators pos. across multiple states and countries • Regulations typically enforced by internal risk control groups, auditors, and management committees • Direct approaches to regulators for rulings or exceptions can be reqired • Accounting • US and Foreign GAAPs, State Statutory (Insurance) • Requires interaction with internal accountants, outside consultants, internal/external auditors, as well as client auditors and consultants • Tax • US state and federal, and Foreign tax codes are all different and all potentially critical • Rating Agencies • For rated deals multiple agencies can be involved and set their own individual standards for structure of the deal and analysis of risks. • Internal Market and Credit Risk Management • Institutions have their own unique internal constraints and considerations that govern what transactions are permitted and how they are percieved • Investors, Clients, Counterparties • Selling the deal to the ultimate buyer may require a completely different set of analysis and consideration than all the preceeding

9. Evidence from a career trajectory

10. Career TrajectorySearch started while still at UCSB • Began job search one year before graduating. Developed a cover letter and resume highlighting: • applicability of my research (Random Matrix Theory) to finance, • founding an investment club, • attendance of finance courses, etc. • Called headhunters, human resource depts., college friends, answered ads • Led to many valuable conversations and two serious interviews • Mobil Oil, Corporate Treasury • Made contact with the head of treasury trading there through a college friend • Thought I was there for an informational interview • Years later I learned that they had been looking for a quant/junior trader, manager liked me for it but his manager was afraid that I would leave too quickly for Wall St. • Bank of America, Global Market Risk Management • Group liked hiring “green” PhD physics and math candidates • Weathered two days of interviews with a total of 11 people • They ultimately made an offer contingent on completion of PhD • Turned in my dissertation on a Friday, hopped in a car and started work Monday. I flew back for graduation a few months later.

11. Career TrajectoryFirst Job: Education and Dues Paying • Bank of America “Technical Finance Consultant” • Reviewed, tested, and signed-off on valuation and market risk (as apposed to credit risk) approaches • Scrubbed and analyzed financial data series • Occasionally helped develop new risk calculations for groups • Represented the bank in audits by the Federal Reserve and OCC • Published a paper on risk management in a popular journal • Participated in a department lecture series and presented original work in mathematical finance • Initially, least experienced member of a team of 9 PhD “quants” (6 physics, 2 math, and 1 engineering) • Got smaller, esoteric (and more interesting) assignments: distressed debt, Brazilian interest rates swaps, Italian equity derivatives, mortgage backed securities trading, … • Management in the risk dept. was not interested in helping PhDs find “Front Office” jobs • Work provided ample opportunity to gain experience and contacts for a self starter • After 1.5 yrs I did get an offer to be a junior trader/desk quant on an interest rate derivatives desk at BofA • Concurrent merger with Nationsbank and a more appealing offer from a New York firm led me to leave anyway. This turned out to be a very good move.

12. Career TrajectoryGood and bad aspects of first job

13. Career TrajectorySampling of first job projects • How to game FX trading limits • Maximum likelihood estimation of jump-diffusion model for securities returns • Automated, ex ante jump identification • Data series “back-filling” • Parameter fitting for enhanced option models • Enhancement of risk measures • Conditional tail expectation of loss

14. Career TrajectorySecondjob search • Focused on New York as deepest job market • Built on knowledge from first job search • Planned a one-week trip 6 mo. In advance • Paid for trip myself but did let interviewees know this • Used 3 headhunters and all personal contacts • Had 27 one-on-one interviews at 5 different companies • Was flown back to New York twice for follow-up interviews • Received 2 offers (by 3 months after initial trip) • Nomura Securities, Risk Management • Constellation Financial, Financial Analyst • Accepted Constellation

15. Career TrajectoryConstellation Financial Management • Started as Vice President, finance analyst • Management sought skilled, assertive, self-directed employees • happy to provide increasing challenge, responsibility, and compensation for success. • In first year as lead analyst/deputy executed • $180 mil. secured loan facility for joint venture with Franklin Templeton funds • $200 mil. of structured notes backed by mutual fund fees: CFM’s first ABS deal. • $175 mil. ABS deal with embedded derivative enhancement from Swiss Reinsurance. Key member “selling” our structure and management services to Swiss Re. • Within 1.5 years promoted to Managing Director and made head of capital planning and asset backed securitization • Promotions come quicker on the front line. • Went on to • Execute 9 more securitizations for a total of $1.3 billion in proceeds • Design and execute first DCA ABS deal with embedded static equity hedges • Manage two revolving credit renewals for $650 million of financing • Structure, “sell”, and execute a $500 mil. “CP Conduit” warehouse for DCA based on static hedge securitization structure

16. Career TrajectorySG acquired Constellation in 2003 • Despite heroic efforts business volume persistently outstripped fund raising • Stock bubble caused banks to cut back on lending • Complexity of our business made is difficult to build new sources quickly • Lack of credit rating limited types of deals we could do for clients • SG is a top global investment bank with enormous resources and client base • SG considered CFM contracts and employees valuable compliment to existing businesses • Increased personal opportunities for development and eliminated risk of employer going bankrupt

17. Career TrajectoryWhat is SG Constellation • A subsidiary of Société Générale Group • 5th largest bank in Europe • 88,000 employees worldwide • Global leader in Equity Derivatives 2004” Equity Derivatives House of the year “ by Risk Magazine, The Banker, and International Financial Review • The key employees of former Constellation are a group within SG’s NY Equity Derivatives Group • Still focused on sophisticated, large scale corporate structured finance deals in the Mutual Fund, Hedge Fund, and Insurance industries

18. Career TrajectoryDirector Financial Engineering • Supervise SG Constellation engineering group; allocate pricing/structuring/development tasks among 4 staff members • Manage new product implementation process • Directly develop and execute critical product initiatives, e.g. Cat Re • Cultivate and execute of profitable trades of bonds from old ABS deals • Develop risk transfer deals with hedge funds and other alternative investment market • Act as a relationship manager for certain counterparties • Bond investors, • Rating agency analysts, and • Certain commercial and investment bankers

19. Career TrajectoryLife at SG Constellation • We work hard • Work day is typically 10 hours long • During critical times hours are much longer and extend to week ends • On late nights company pays for meals and limos home • Budgets for software, computing power, outside advice, travel, etc. all as high as projects merit. • Work conditions are hectic • On a “desk” in a wide open “trading floor” amid constant noise and activity • Discussion often require moving to private conference rooms • Colleagues are high quality • Management is very experienced, intelligent and rational • Co-workers all intelligent, resourceful people with advanced degrees and designations • I continue have much to learn from the people I work with • Total compensation is generally high but varies directly with performance of group and individual • Discretionary portion (bonus) is can range from 1/4 to 4x base compensation depending on job and performance

20. Representative ProjectStatic Hedged Mutual Fund Fee Securitization

21. Representative ProjectHedged Mutual Fund ABS • Circumstances • Constellation relied on regular securitization of assets to fund new business • The 2000 stock crash caused portfolios backing existing deals to drop precipitously in value, making the bonds “distressed” • Constellation’s own portfolio was unaffected because of expert dynamic hedging • Problem • Investors would no longer buy our bond deals because market risk was perceived to be too high. Embedded hedging would appeal to them but dynamic was not acceptable. • Solution • We developed a structure that incorporated a sophisticated, cost-effective static hedge that would protect note-holders without the need for any dynamic management

22. Representative ProjectConstellation had an excellent historical dynamic hedging performance

23. Ratings on DCA backed bonds are based on detailed Monte Carlo Simulations of future cash flows. The note size at a particular rating and coupon is determined by comparing note performance with rating agency criteria for frequency and severity of default. In 3000 Monte Carlo scenarios a AA bond should be effectively default free. Since unhedged DCA is relatively risky, the amount of L+80 AA paper that can be issued is not a high percentage of asset value.

24. The Total Cash (discounted at the debt coupon) Shows High Correlation with Basket Return for a static hedge basket designed by Constellation. This indicates that it is possible to hedge the risk of the DCA using a derivative that is based on the index basket. 20% O/C Required when Un-Hedged The observation that index basket returns correlate so highly with DCA performance led to the creation of a successful hedged structure for AA rated notes that was employed in the FEP 2002-2 securitization.

25. In order to achieve high advance rate and low funding cost while insuring notes obtain a AA rating, the risk of the underlying mutual fund fees was be mitigated by a derivative based on an “index basket.” • The assets of the securitization include an “Asian Style-European Execution” put option. • The option payout is based on the average performance of a basket of market indices that are correlated to the performance of mutual funds underlying the transaction. • All the parameters of the option, including the basket weights, the exercise date, the strike price and the notional underlying were determined using historical shareholder behavior and fund performance data as an input to a non-linear optimization calculation. The objective of the optimization was: • maximized net cash proceed from securitization by reducing the exposure of the notes to NAV fluctuations in the underlying funds • subject to satisfying • rating agency criteria for a long term AA credit rating, and • Investor criteria for historical stress testing of structures • At the expiry of the option, the securitization receives an automatic, one time payment if the average level of the basket of indices over the option period is below the strike price. • During the months before and after option payout, full “turbo” amortization of the debt, interest reserves against servicing disruption, and ample cash flows from the DCA (up to 7x interest coverage) insure reliable debt service.

26. The Option Payout Is Sized to Offset Loss of Cash Flow When Market Return Is Low

27. By adding the optimal hedge to the assets of the SPV, Monte Carlo simulations show that the total cash from assets is stabilized and the amount O/C required to support AA notes at a particular coupon is reduced substantially. 5% O/C Required when Hedged

28. Constellation successfully executed a $165 million of AA rated, static hedged bond deal in June 2002The deal has performed very well through up and down markets since

29. Representative ProjectThe deal has performed very well through up and down markets since.

30. In 2003 we built on the success with the static hedged securitization to build a $500 million secured bank facility FEP Securitization VII Hedge Counter- party FEP Sec-VIII Cash (Put Premium) Put Option Mutual Funds FEP Capital, LP Originator FEP Warehouse Funding FEP Sec-IX DCA DCA + Put Option DCA Cash + Equity Cash + Equity Cash FEP Sec-X VFN CP Conduit Acquire DCA Warehouse in Interim Term Securitize

31. In 2003 we built on the success of the static hedged securitization technology to build a $500 million secured bank facility

32. New ChallengeVariable Annuity Crisis … …

33. Making the transition

34. Making the transition • Though you’re inexperienced, you have many qualities that Wall St. firms value • Technical mathematical knowledge • Modeling and problem solving ability, critical thinking • Programming skills • Ability to communicate complex quantitative finance concepts to “laymen” • Low (initial) pay requirements (by Wall St. standards), relocation flexibility • Ability to absorb large amounts of complex information in a short period of time Finance professionals know they have a chance at successfully teaching you business and accounting principles on the job, but they’re likely never going to be able to teach an accountant how to solve non-linear PDEs.

35. Discoveries from a first job search • You need a resume but your interview performance will determine whether get you the job • A succinct and compelling cover letter is also a valuable and can differentiate you • Since you have no real experience it is important to show prior initiative • Attend quantitative finance classes, and/or start CFA program • Do sideline mathematical finance research work • Get personal investing experience • Even your average physics geek will discover many valuable contacts upon reflection: Undergraduate classmates, family friends, relatives, professors and alumni • Most online “ads” for quantitative finance positions are by headhunters fishing for candidates • If you can get them interested headhunters may lead to the best positions • Don’t be shy about working with many at once • New York firms will not pay for a green candidate to travel for interviews • Many managers will be willing to sit down for an interview if you are already in the city even if you are not ideally qualified • Even if no job is available an informational interview are extremely valuable for gaining • Interview experience • Connections with others that can help you • Future job and networking opportunities • Plan a trip that you pay for, many months in advance. Fill up your schedule as best you can interviews, even if they are only informational

36. An Extremely limited list of other UCSB folks in business/finance that I know of:

37. I recommend these books as a foundation for financial engineering and as preparation for a job search:

38. Check out these works to get a flavor for the background and culture of the Wall Street

39. These are some sites and journals I recommend perusing

40. Professional Education, Designations, Certifications • CFA Designation www.cfainstitute.org • Provides a solid “crash course” in accounting, economics, investment valuation and management, and all the topics your typical physicist did not study in school • Self-study and test format is cost/time effective • Can be started while you are in school and continued after you get a job • Designation is respected (especially asset management industry) and will help avoid your being considered too “academic” • Others FRM, CFP, etc. • Less applicable or recognized • SEC Licenses: Series 7, etc. • May be required by employer • Easy for quants; can be successfully crammed • Commodities license can be obtained without an employer • Financial Engineering Masters Programs • Many schools (NYU, MIT, Columbia,…) offer a program aimed at folks with technical backgrounds in other fields like math and physics • If UCSB offered one I would probably recommend considering it

41. Becoming a QuantWhat you can expect • An industry that will welcome and value qualities honed in physics • Long hours/Hard Work • Attractive Pay • Interesting challenges • A great deal of non-trivial learning necessary • Opportunity for original research or authorship if inclined

42. Making the TransitionExperimental Observation • Networking is critical to “breaking in” • Use headhunters • Get informational interviews • Need a solid “Hull” level understanding of derivatives for interviews • Show evidence of commitment through math finance study • A transitional job will be helpful or necessary on way to most interesting assignments