The Midas Formula: Trillion Dollar Bet

The Midas Formula: Trillion Dollar Bet

2000, Economics  -   34 Comments
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The Midas Formula: Trillion Dollar BetThe history behind perhaps the greatest formula ever created in finance: the Black-Scholes-Merton options pricing model. Two of its creators were awarded the Nobel Prize in Economics in 1997. A year later their hedge fund Long Term Capital Management (LTCM) had collapsed with staggering losses of $100 billion due to significant leverage of the strategy.

The Black-Scholes Formula was derived by observing that an investor can precisely replicate the payoff to a call option by buying the underlying stock and financing part of the stock purchase by borrowing. Only five variables were needed: the price of the stock; the exercise price of the option; the risk-free interest rate; and the time to maturity of the option. The only unobservable is the volatility of the underlying stock price.

The main problem with the framework (which assumes the ability to use risk-free arbitrage and dynamic hedging in continuous time) is that it doesn't consider how a change in market dynamics (specifically liquidity risk and default) can affect overall market sentiment.

This means the prices of assets can in some extreme cases depart from what the formula says should hold. LTCM was brave and took a contrarian view. It borrowed even more in the face of the perceived profitable outcome. Instead the reverse happened (things just kept getting worse day after day).

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David Nawrocki
David Nawrocki
7 years ago

We (taxpayers) did not bail out LTCM. The bailout was financed by Wall Street firms orchestrated by the Fed. I think the positions were liquidated with a very small loss, if any, over time. Without the TARP and the Fed bailout in 2008, the economy would not be where it is today. Following what happened during the Depression, the economy would be in much worse shape. During the Depression, unemployment maxed out to over 25% - we only reached 10% in 2009. Everyone is correct that this was a lesson that Wall Street and Congress did not learn. John Meriwether went bust again in 2008 and is currently trying a third time. Financial markets and banks are not inherently stable and need to be treated the same as public utilities. Black-Scholes-Merton assumed that markets are stable entities which did not turn out to be true. Financial markets are a wonderful creation but unfortunately, like the golden goose, easily abused by greedy idiots.

Weasel Spleen
Weasel Spleen
7 years ago

@yahoo-HH36YO5DPQKA3NPDWBWSHPLWKU, as an American, I would like to be outraged and offended by your comments, but unfortunately, I can't, because about 90% of it is absolutely true. I do take issue with "The vast majority of americans tend to be non-thinkers. " Majority, maybe. Vast majority? No. There are still plenty of us who don't like NASCAR.

dieniggerdie
dieniggerdie
10 years ago

Dam Mel Gibson was right!

CanuckDriss
CanuckDriss
10 years ago

The American-centric formula worked perfectly for a docile business environment that's the US. The assumption was that the rest of the world would follow, Thailand crash followed by Russia's default as outside factors couldn't have been predicted and if if they were, they were viewed as outliers to be tamed with more borrowing and hedging, Of course, this attitude only produced more hemorrhaging and losses. It beats me that folks whose action dispossess millions and helped worsened a world economic crisis are still enjoying the good life, while someone who steals a slice of Pizza to feed himself is locked up in jail. Ten years later in 2008, the same thing happened with default swaps derivatives fiasco which created the biggest recession in recent history. The culprits are still making millions of bonuses while people lost their homes by the millions!!!

may
may
11 years ago

taking RISK out of their equation was pure arrogance

yahoo-HH36YO5DPQKA3NPDWBWSHPLWKU
yahoo-HH36YO5DPQKA3NPDWBWSHPLWKU
12 years ago

Anyone who says the usa and the UK are the same ought to pull their american head out of their a*se!

Notice how the anti-government rebels of the BBC (in the UK!) tell more truth through the UK's essentially FREE media than the state-run corporate mouth pieces of the usa in their 'supposed' 'free' 'libertarian' state.

Want to know what's going on in the u.s. of a? Read the foreign media... we have no edict to support your faltering regime.

usa is free? Think again!

How many of the docs on THIS website, the good ones, were made by american corporate tv companies? How many by the 'much derided' BBC? Remind me who has free speech again?

Intellectualism in the usa is essentially dead.
'Debate' in the usa consists of shouted irrelevances, screamed distortions of the truth and red-herring accusations, each of which interest the illiterate and uneducated amer-public but would be laughed away here in Europe.

Most americans don't think... why should they? They don't have to! They are born to be trained to buy shit they don't need with money they don't have lent to them by criminals that direct their every thought and deed and word and form their worldview from an early age.

YET most americans firmly believe; "Europe = bad; usa = bestest #1 in all things, period!", "Greece extremely important and dollar collapse impossible!", "Magic jesus will protect the holy dollar as the only world reserve currency that can be imagined... or somesuch", "The usa goes down (too big to fail!) and whole world finished therefore..."

The vast majority of americans tend to be non-thinkers. That would be why you don't get an 'A' for your nation's name. For most of 'em, give them some corn syrup and some saly food, plop them in front of some Nascar +nasty beer and they're as happy as a congressman in a brothel!

"We laugh at americans. therefore we are!"

But then that would be an america you don't recognisem right?
Go on... respond by telling me some more stereotypes about myself some more!

"usa good; 'u-rop bad"
Chant with me!

FreemonSandlewould
FreemonSandlewould
12 years ago

Had they kept the formula to themselves and traded using it.....
had they combined forces with an experienced trader .......

they could have gone on for decades.

But once the secret is out. The only thing that CAN happen is violation of its predictions because people not wanting to lose will find a way out of the flight envelop of the equation.

Rfrmr
Rfrmr
12 years ago

There is no Nobel Prize in Economics. Only the "Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel". Probably because Alfred Nobel himself didn´t think there was anything to reward in this field...

Piron
Piron
12 years ago

lol, this guy talks as al pacino and thinks he his a master or something belongs to him
He did what?? change money in money...pf
I change my words inna truth!!
without hands!!

Rocky Racoon
Rocky Racoon
12 years ago

Sh8t I just wrote a long comment hit the enter button and poof it didn't turn up anyway a real good website and I am not going to send you to a commerical website and try and sell you some shoes. It is called globalresearch.ca It is in Montreal and it has some very enlightening material about all of these political and economic situations. Seems we are heading towards ww3. After Libya I can believe it. In any case I am sick to my stomach over my countries participation in these imperialist adventures and can't take to much more before I either leave the country or drink myself into a coma everyday. Since I already have liver disease it wouldn't take more than six months to finish me off.I cannot beleive how politically backward so many of my fellow's are and the corporate media is doing such a number on us I don't know how the heck we are going to beat back these war mongers. That is all I have to say for now anyway webmaster thanks for all you do here.
Yours,
RR

P.M. Rangarajan
P.M. Rangarajan
12 years ago

Did America learn from this LTCM debacle. Nothing. Did Europe learn from this debacle, No. Alan Greenspan and other officials should have jailed those two Nobel Laureates at that time itself, instead of bailing out LTCM, so that the next trader in Goldman,Merrill Lynch, Bear Stearns, Lehman and Morgan Stanley would not have done the Synthetic Propping,The biggest crisis in 2008, would not have happened, which unfortunately still continues. Instead of that Myron Scholes saying that he felt "bad" after the LTCM debacle is the grossest understatement of the human greed. He would not have said it had he been punished. CDOs,Synthetic Derivatives and all other mathematical mumbo-jumbo would not have seen the light of the day, if those two were prosecuted. Miilions of investors would have been saved. All that TARP and other EFSF need not have been enforced. WHAT IS THE BOTTOMLINE OF THE STORY. HUMAN GREED. Sometimes I feel, ignorance is bliss.If time permits please read the book by Mandelbrot titled "Misbehavior of the markets" B&S Formula is torn to pieces. It is always luck, my friend, to win an event. Any amount of tinkering with mathematics will not solve the problem as it is an exact science and market is totally a subjective place. Economic activities though are tweaked to suit the market can show its ugly face in the long run and those who are smart enough like Madoff win hands down.

Rocky Racoon
Rocky Racoon
12 years ago

This is why instead of democratically and rationally determining where we want to dedicate our resources they demand that we leave it up to the market-so they can continue to play their games. This is not the way to determine how to allocate resources. That is clear to me at least.
RR

Far Spam
Far Spam
12 years ago

Trading is the only way to make money....
If you are doing anything else you are just a slave to a trade!

This doc is so funny. The pits today are practically empty. Trading happens online and is becoming much more automated.

Every bank is trying to come up with a robot that will be quicker and better at trading.
Guess what.
Robots eventually become predictable ;-)

RileyRampant
RileyRampant
12 years ago

it appears the original formula did & does have some value. where they erred was turning it into a magic carpet they could ride into the land of milk & endless honey.

the fall-out from this arrogance was a perfect warning to the fed, the sec, the congress, the investment bankers - all of whom disregarded it completely, of course.

see: pbs- the warning

Guest
Guest
12 years ago

Did the guys in the pit learn their trade on the race course? they're just tic-tac men.

Evan Jones
Evan Jones
12 years ago

Investing in the stock market is far worse than gambling. With gambling, the game is fixed in terms of the odds and rules. In some cases like black jack your own skill can help improve your odds (Unlike roulette) . The stock market? That doesn't work on rulles and fixed odds. It works on "SENTIMENT" Human behaviour. The fact that you place a bet then effects the Sentiment pool and you have know way of reading ahead what the sentiment is unless you are xavier from the X Men. You can only react. The only way to win is to play outside of the rulles that the rest of us have to play within. in other words you need corruption on your side. Of cours the investment community need suckers because thats were the money comes from.

cezy
cezy
12 years ago

You can simplify as much as possible, not more.
Maybe academics are not fit for the real world...

Knud Sandbæk Nielsen
Knud Sandbæk Nielsen
12 years ago

Creating such a formula is in it self bound to push the market out of balance. every time you invent a new trick, you change the game. Consequently there is an opening for yet another new trick for this new and changed game.

And just like a pyramid scheme, this will eventually fall down as the cheap magic it is. "Did you really think you could make money out of nothing for ever?" is the question that comes to mind.

KsDevil
KsDevil
12 years ago

So, here we are again bailing out the Wall Street gamblers. Lesson not learned. If history repeats(again), we can expect another feel-good bubble followed by investors regret and tax payers funding the clean-up. Even after positive gains in middle class investments (401K) during the next bubble, there may be no net gain when it comes time to pay out to "save" the economy. Maybe Sealy will market a money pouch in their mattresses.

anuragawasthi
anuragawasthi
12 years ago

The 1930's mess occurred coz the govts at that that did not had much tools
to adjust the monetary situation and the current one is due to the fact that
now we have many tools and all of them have been abused

Guest
Guest
12 years ago

@HyunSu Kim

Yeah "that Russia would do what they did and prevent having"; But don't omit that they remained "Homosapiens" in the sense that once they were faced with a failure, they reacted just like most if not all human beings by a panic and went to borrow more money that sunk them even in even deeper problems.
Until total disaster. That isthe nature of the beast.

They sure had the competency but not the wisdom of an every day practice.
In fact, all the time they spent to study, it was on the purpose of not having to work for earing their bread & butter.
As seen on a daily basis in technology.

Pierre.

Thomas Keddy
Thomas Keddy
12 years ago

why do we even need traders, do the help the economy at all other than making a few ppl really rich. anyone.

Guest
Guest
12 years ago

But the guy who worked/created the algebra equations, established the "Live" continuous determination of stock option values appears to still have "An acceptable" way of life?
For the least, based on the inside of his house while he was interviewed at the end of the docu?

Bwarf! That occured only in the USA anyhow.
But drown many worldwide investors.
It ain't the end of the world I guess.
It'll be paid by the average USA tax payers.
Though, who said that the USA doesn't have "Communist" habits". If the average USA citizen pays for the mess of a private business, what's that political system supposed to be called? Banana republic?

In the end, I wonder why these guys who though of this, were not simply sent to standar school and learn how to earn their bread & butter like everyone?
They sure like to gamble.
With their fellow citizens money, of course!

Pierre.