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Into Black-Scholes: where all the money went

Written By: - Date published: 11:14 am, May 2nd, 2012 - 15 comments
Categories: capitalism - Tags:

A very interesting article on the BBC – the financial formula that ruined the world.

Well, that’s a bit sensationalist, but it’s a formula that allowed intuition to be taken out of “options” trading and computers to move in.  And with the “understanding” of the maths of futures there was a move into more and more complex derivatives.

Around 1970 Professor Myron Scholes and his colleague Fischer Black worked out a formula so that if you have the right combination of a commodity and options to buy and sell that commodity you end up with a “risk-free” portfolio.

“We were like kids in a candy story in the sense that we described options everywhere, options were embedded in everything that we did in life,” said Scholes.

And so faster and faster trading of derivatives followed – by 2007 $US1 quadrillion in derivatives were being traded: 10 times the total production of goods in human history.

But with faster trading and more complex derivatives came problems.  Traders were more vulnerable to simplifications and mistakes.  And with everyone using very similar formulae, in the event of a large movement unpredicted by the formula everyone gets the same sell result…

Scholes received the Nobel prize for economics in 1997; in 1998 his hedge fund crashed.  The firm lost $4bn in 6 weeks with the Russian financial crash, but hedge funds and banks didn’t change course.  10 years later it was Lehman Brothers.

Professor Ian Stewart of Warwick Uni describes it as a morality tale:

“It’s very tempting to see the financial crisis and various things which led up to it as sort of the classic Greek tragedy of hubris begets nemesis,” he says.

“You try to fly, you fly too close to the sun, the wax holding your wings on melts and you fall down to the ground. My personal view is that … the bankers’ hubris did indeed beget nemesis. But the big problem is that it wasn’t the bankers on whom the nemesis descended – it was the rest of us.”

So we end up with the debt, bailouts and pain; and meanwhile the bankers bonuses keep rolling on in and executive salaries keep rising…

15 comments on “Into Black-Scholes: where all the money went”

  1. The Baron 1

    A bit sensational indeed. The article makes reasonably clear that it wasn’t so much the model that ruined the world, but the way in which it was used: – for example:

    “Not all of those subsequent technologies, says Scholes, were good enough. “[Some] had assumptions that were wrong, or they used data incorrectly to calibrate their models, or people who used [the] models didn’t know how to use them.””

    In other words, it was the uses of this model are what ruined the world rather than the model itself. This is always the way in economics and finance though – you have to “lab” to test theories in, so unlike other sciences, you have to live with the consequences and errors of your experiments.

    In a way, this is the same as the great socialist experiments of the 20th century – except most of those ended with everyone starving to death rather than simply going broke; or the great NZ experiment of the 80s, where we don’t yet seem to have turned into the envy of the developed world… for all of these negative examples, there are plenty of positive ones where the economic theory has been bourne out well.

    Roll of the dice, I guess.

    • Poission 1.1

      The axiomatic assumption of BS is arbitrary eg pricing follows a geometric Brownian motion with constant drift and volatility.

      This is an incorrect assumption as it susceptible to random chance ie Black Swans.such as the CHCH event .Leemans Southern Cross etc.

      All open systems experience interference which tends to breakdown the mode locked system,this can either be from an external shock or instability from within the system.

      There is a significant distance between the mathematical physics community and the financial modelling community ,a good example is where Bob May is a co author,where the authors suggested that the “infected” banks should have been quarantined .

      http://www.nature.com/nature/journal/v469/n7330/full/nature09659.html

      • Poission 1.1.1

        here is the relevant part from Haldane and May

        Events external to the banking system, such as recessions, major wars, civil unrest or environmental catastrophes, clearly have the potential to depress the value of a bank’s assets so severely that the system fails. Although probably exacerbated by such events, including global imbalances (China as producer and saver, the United States as consumer and debtor), the
        present crisis seems more akin to self-harm caused by overexuberance within the financial sector itself. Perhaps as much as two-thirds of the spectacular growth in banks’ balance sheet over recent decades reflected increasing claims within the financial system, rather than with nonfinancial agents. One key driver of this explosive intrasystem activity came from the growth in derivative markets.

        In 2002, when Warren Buffet first expressed his view that ‘‘derivatives are financial weapons of mass destruction’’16, markets—although booming— seemed remarkably stable. Their subsequent growth, illustrated in Fig. 1, has been extraordinary, outpacing the growth in world gross domestic product (GDP) by a factor of three. In some derivatives markets, such as
        credit default swaps (CDS), growth has outpaced Moore’s Law. These developments contributed significantly towards an unprecedented influx of mathematically skilled people (quantitative analysts) into the financial/ banking industry. These people produced very sophisticated techniques (including APT), which seemingly allowed you to put a price on
        future risks, and thus to trade increasingly complex derivative contracts— bundles of assets—with risks apparently decreasing as the bundles grew.

  2. ianmac 2

    So we end up with the debt, bailouts and pain; and meanwhile the bankers bonuses keep rolling on in and executive salaries keep rising…

    Have been wondering about that. With any of the Bill English austerity measures can you point to any which would seriously affect the higher income people, apart perhaps from losing their jobs?
    Conversely what effect do the measures have on the lowest quarter of income earners?
    Someone must have worked out a definitive effect.

  3. Draco T Bastard 3

    The real problems are money and greed. Money allows the “economy” to move into delusion and greed pushes people to want more and more. Unfortunately, our economic theories are based upon these problems.

  4. Glad someone at the Standard finally starts looking at international finance.

    As we speak 84% of all trade is done by high frequency trading computers and only 16% by human traders. High frequency trading is a system not just for trading but it is a means to manipulate the market in the direction the big banks want it to go. It is also used to destroy countries such as Greece, Spain and lately my country of origine Holland.

    Without a trace the too big too fail banks including John Key’s Bank of America manipulate the stock market at their hearts content raking in billions of digital cash which have nothing, absolutely nothing to do with the main street economy which in the US for all intends and purposes has gone the way of the dodo.
    In the mean time Central banks around the world are printing money like there is no tomorrow and globally wages are stagnant causing inflation and deflation at the same time with food prices rising and the not so important stuff dropping in price causing whole sectors of production in China to collapse too.

    Here is what Max Keiser and Ellen Brown (Web of debt) have to say about the high frequency trading fraud. In the 2010 interview the percentage of high frequency trading was only about 70%.
    The software programs and derivatives algorithms by the way were developed by banks such as Merrill Lynch in the late 90s and here is a quote from John Key about his time as the manager of the Bonds and Derivatives department of Merrill Lynch:

    “I had a whole lot of people working for me who were at the cutting edge of delivering quite complex and new and innovative products. They tended to either be a new product or into a new market, usually the emerging markets, Russia, Brazil, Argentina. I wasn’t the guy sitting there dreaming it all up, but I was the guy who was responsible for those people.” Unauthorised biography July 2008 NZHerald (Eugene Bingham)

    In fact it can be argued that the Black Monday economic collapse may have been one of the first computer generated collapses and it was only four days later that patient zero Bankers trust forex trader Andrew Krieger with the aid of non other than John Key (solely responsible for the trades) attacked the NZ dollar with the first computerised Derivatives attack in history.

    • Gosman 4.1

      There is no hard evidence that John Key was working with Andrew Krieger during the late 80’s ‘attack’ on the NZ dollar. Regardless of this is the fact that Krieger took a position that the NZ dollar was overvalued and was therefore proved right. There isn’t anything wrong with this. It could be argued that Krieger in fact helped the NZ economy by lowering the NZ dollar and therefore the Export sector.

      • travellerev 4.1.1

        The shill again!

        Here is the link to my open letter to Eugene Bingham after which the NZ herald removed 5 pages from the unauthorised biography, Funnily enough all the pages pertaining to the banking career of John Key.

        Thanks Gosman for opening this door to inform more people and please people make up your own mind

        • Gosman 4.1.1.1

          Once again you have no hard evidence that he was working with Krieger, mere fantasical speculation on your part.

          You also haven’t dealt with the fact that causing the NZ dollar to devalue to a more suitable level helped NZ exporters so I’m unsure why you think this is a bad thing.

          • travellerev 4.1.1.1.1

            Interesting! It seems important to you to keep John Key and Andrew Krieger and the first (Krieger named patient Zero in a book about how we got into the derivative mire) derivatives attack on a currency, repeated in Thailand (again hitting the Kiwi’s in their wallets) 
            Krieger and John Key were connected with each other in two important newspaper articles which both quoted his boss as saying that the money was in the millions and that John Key was the sole counter part. John Key says he can’t remember whether it was buys or sells (Funny thing amnesia) and that it was in August 1088 anyway which is a lie.

            Andrew Krieger according to three different newspaper articles, all downloaded and archived in hard copy by the way, had left the Bankers trust in December 1987 and trading in June 1998 after a short spell with Soros. The only time Krieger dealt in that unknown little currency the NZ dollar was in the week after the 1987 Black Monday while both him and John Key worked for the then unregistered (They could trade but not perform other banking functions and registered in August 1988) Bankers trust.

            So we’ve got a lying John Key and a provable connection to millions of trade with Andrew Krieger who only dealt in those massive amounts of money on that fateful day.

            I wonder what a judge would say. Having said that what is of course is the real tragedy is why the MSM does not ask him about that very first derivatives attack and how he knew the product would cause the financial house of cards to collapse.

            Here is what he had to say about it on breakfast TV not so long ago.

            By the way Gossie it’s almost time to go home and thanks again for the exposure and saying there is no hard evidence doesn’t make it so just because you don’t want it to be.

            • Gosman 4.1.1.1.1.1

              From what I know the ‘attack’ on the NZ Dollar did not involve derivatives. Where is your evidence that it did?

              [Edit: It does indeed seem like it involved options trading ]

              • In 1986, [Bankers Trust] hired a young currency options trader from Salomon Brothers called Andy Krieger who had graduated from the Wharton School after studying Sanskrit and philosophy at the University of Pennsylvania. He quickly became one of the most aggressive dealers in the world, with the full sanction of Bankers. While most of the bank’s currency traders had an upper dealing limit of $50 million, Krieger’s was in the region of $700 million—around a quarter of the bank’s capital at the time. By using options, Krieger could leverage this exposure to many times that size ($100,000 of currency options would buy control of $30 million to $40 million in actual currency). In 1987 he did this to launch a speculative attack on the New Zealand dollar. If his own claims can be believed, he sold short the entire money supply of the country. In a matter of hours, the NZ dollar plunged 5 percent against the U.S. dollar. It was enough, at any rate, to draw an angry complaint from the New Zealand central bank. But with typical arrogance, Sanford later turned this on its head. “We didn’t take too big a position for Bankers Trust,” he grumbled, “but we may have taken too big a position for that market.” It was New Zealand’s fault, in other words, for being too small to cope with Bankers. (from Apocalypse roulette)
                Using the relatively new techniques afforded by options, Krieger took up a short position against the kiwi worth hundreds of millions of dollars. In fact, his sell orders were said to exceed the money supply of New Zealand. The selling pressure combined with the lack of currency in circulation caused the kiwi to drop sharply. It yo-yoed between a 3 and 5% loss while Krieger made millions for his employers. (Investopia)

                 

                • Gosman

                  You still haven’t explained why this is a bad thing. Lowering the value of the NZ dollar helped NZ exporters. It is in fact what I see many leftists argue needs to happen in NZ today.

  5. Rich 5

    Around 1970 Professor Myron Scholes and his colleague Fischer Black worked out a formula so that if you have the right combination of a commodity and options to buy and sell that commodity you end up with a “risk-free” portfolio.

    Sorry, but this is totally bogus.

    Portfolio risk and Black-Scholes are different things. If you have multiple options and underlyings, simple arithmetic gives you the risk profile – how much you gain/lose at each price. If that line’s flat, then it’s risk free (but it would typically be flat negative – you’d always make a loss).

    The Black-Scholes formula takes one number (option price) and turns it into another (implied volatility). You can run it backwards, but to get a useful answer, you’d need to predict the future volatility of the underlying commodity price. It helps traders, but it isn’t a magic formula that you just run and out comes profit.

  6. jack 6

    The Black-Sc holes formula is work wondered because these formula has some negative points . I agree for this post but my friend previous some year all of the word under the reaction .find more information related to more formula visit http://tradingcomputersonline.com/

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