Black-Scholes: The formula linked to the financial crash

[Ferru123]

http://www.bbc.co.uk/news/magazine-17866646

[Euler]

Have a read of the book 'When genius failed' if you want the full story on LCTM.

The upshot is they leverage massively and that's what busted them. I think there were leveraged something bizarre like 125-1

[PeterLe]

I remember doing the Black-Scholes at uni. We were all presented with 2/3 year old copies of the FT (and other info) and then had to choose stocks that we thought would rise by applying the BS equation. Weeks later we were then given current copies of the FT to see if our predictions came true.
We did have a level of success to be fair, but I often wonder if this was a self fulfilling prophecy as no doubt some of the professionals were doing the same?
..and they made us calculate it long hand with a calculator! Hell of a formula (never did really understand it!)

[Ferru123]

Do you think that that the fact that the Black-Scholes model assumes that the market is rational (and therefore doesn't allow for crazy bubbles) was a contributing factor?

Jeff

The upshot is they leverage massively and that's what busted them. I think there were leveraged something bizarre like 125-1

[Will Sharpe]

Have a read of the book 'When genius failed' if you want the full story on LCTM.

The upshot is they leverage massively and that's what busted them. I think there were leveraged something bizarre like 125-1

Yes I think that no matter how much work is put in by the quants there isn't the equivalent amount of analysis done on the risk side of a applying a model to a market or multiple markets under duress. Risk management is hard enough when it comes to individual assets / positions. Try to assess the covariance of different assets classes on a global scale when the underlying value of your portfolio is larger than most countries GDP. Try to rebalance that portfolio the day after an incident like 9/11 and there won't be a model around to cope with it.

Do that with 125/1 leverage and you'll see that your equity of 8% was wiped out before the first hour of trading

[Euler]

Do you think that that the fact that the Black-Scholes model assumes that the market is rational (and therefore doesn't allow for crazy bubbles) was a contributing factor?

Jeff

Black-scholes is simply a brilliant equation and it can teach you a huge amount if you are prepared to study it in depth.

The systemic problem with it though is two fold, you only now what level of volatility to apply historically and you need to apply it to the correct problem.

LTCM over leveraged and didn't account for fat tails in thier risk and ultimatley human behaviour. Long term thinking isn't a option for the highly leveraged.

LTCM's equity tumbled from $2.3 billion at the start of the month to just $400 million by September 25. With liabilities still over $100 billion, this translated to an effective leverage ratio of more than 250-to-1

[Euler]

The sad thing about LTCM is that they nearly brought down the entire financial system. But nobody learned.

When I was on a trip in the US in 2004 I saw a presentation on derivatives, including CDO's, where the presenter showed how both buyers and sellers were booking a profit and questioned that this couldn't possibly be true. Buffett described them as weapons of financial mass destruction. Both were totally spot on, but despite making a fuss about it the establishment chose to ignore it. The very last article I wrote in a financial magazine highlighted similar issues in the banking system, but I doubt many people took notice.

You can't escape the fact there were plenty of warnings about the impending disaster but policy makers did nothing about.

It's sort of lurched from one crisis to another.

LTCM, Dot com boom, Housing market, Now sovereign debt. You can't help but think that the whole system needs a complete reboot.

[Ferru123]

Black-scholes is simply a brilliant equation and it can teach you a huge amount if you are prepared to study it in depth.

I am in two minds about Black-Scholes. Part of me wonders if it is the financial markets equivalent of the General Theory of Relativity; a work of genius that wraps the market into a neat little ball. But I can't help but wonder if it is fatally flawed, as it ignores the human factor, and erroneously assumes that the markets are rational (despite a mountain of evidence to the contrary).

Do you consider it conceivable that LTCM would have eventually failed even if they had used much more conservative staking, as a result of the many bubbles that have occurred?

I get the impression that what Black-Scoles essentially does is look at a market's historical volatility to predict the price at the time an option matures, and exploits the random Brownian motion of the market to achieve value bets. In a way, it's a bit like looking at a Betfair horse market 5 minutes from the start (say), and predicting the BSP. Am I thinking along the right lines?

BTW, do you have a link to that article you wrote?

LTCM, Dot com boom, Housing market, Now sovereign debt. You can't help but think that the whole system needs a complete reboot.

The system isn't perfect, but I'm not sure there is a better system out there. The problem IMHO isn't with the system, but with the fact that, as with any system, there will be people who act selfishly and/or stupidly. I'm not convinced that we've really moved on as a species since the Dutch tulip bubble hundreds of years ago...

Jeff

[Euler]

I think the problem is that people are too quick to take a fast buck and very few people have the patience and foresight to add genuine value to the system. This creates outsized risk rather than true value.

[superfrank]

fear and greed. i don't think we'll ever have a system that can eliminate these 2 drivers, but we could certainly have a system that has the potential to be far more stable and reward real investment and hard work rather over extreme risk taking and manipulation.

it's a real shame that some of the brightest minds are now employed in "financial engineering" rather than something more worthwhile.