
The History of the Black-Scholes Formula - bpolania
http://priceonomics.com/the-history-of-the-black-scholes-formula/
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lucozade
What a load of hogwash.

LTCM's problem wasn't anything to do with the Black-Scholes model. In fact far
from it, LTCM's market risk management was very good (for its time).

Where they became unstuck was in liquidity and capital risk management. Where
the banks got unstuck wrt LTCM was in credit risk management.

Where the banks didn't learn the lessons of LTCM was in them still not being
good enough at liquidity and capital risk management come 2008.

And one more tangential point as I see this reasonably regularly. The key
insight from Black-Scholes isn't the use of normal vols. It was known pretty
much straight away that a lot of market where it was used weren't normal (in
the probabilistic sense).

The key insight was to use the no arbitrage concept for pricing derivatives.
This was and is a hugely powerful tool and was an asset to financial
management (excuse the pun).

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tdees40
This is a pretty silly piece.

First of all, the vast majority of LTCM's trades had nothing at all to do with
the Black-Scholes-Merton formula (BSM). They were just highly levered mean
reversion trades. The fall of LTCM had nothing to do with the BSM formula, it
had everything to do with leverage.

Secondly, vanilla BSM with constant volatility isn't really used to do
anything important anymore. It was going away much earlier than 1997 anyway;
the Heston model came around in 1993, and Derman was using a primitive version
of local vol around the same time. And of course people knew that financial
asset returns were not normally distributed with constant vol (Mandelbrot
wrote a paper describing that in 1963!).

I won't even get into why his (and Salmon's) description of how the Li formula
was used is completely wrong.

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applecore
This is more accurately the history of Long-Term Capital Management, not the
BSM formula (which really began in 1900 with Bachelier's _Theory of
Speculation_ ).

~~~
bobcostas55
I believe Theory of Speculation also features the first appearance of Brownian
motion. Bachelier was extremely far ahead of his time.

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chollida1
This article seems like it was "borrowed" very heavily from this book:

[http://www.amazon.com/Inventing-Money-Long-Term-Capital-
Mana...](http://www.amazon.com/Inventing-Money-Long-Term-Capital-
Management/dp/0471498114/)

Most people read this book but I think the above book is much better.

[http://www.amazon.com/When-Genius-Failed-Long-Term-
Managemen...](http://www.amazon.com/When-Genius-Failed-Long-Term-
Management/dp/0375758259)

I'd recommend reading both if this sort of thing interests you, in the order
that they are listed.

Since this article is mostly about LTCM, its kindof interesting to look at
their downfall and realize that in the end they were right, their trades ended
up being profitable, they were just so leveraged that when the markets started
to diverge they couldn't make their margin calls.

Interestingly the reason things went south so fast was that LTCM and the banks
had different risk models.

To LTCM they would do spread trades, where you take 2 very similar
instruments, the article mentions 29.5 and 30 year bonds. You short the one
you think is expensive and buy the one you think is cheap and hold them until
the prices converge.

This has a nice risk management feature that the risk on both cancel each
other out almost as if the markets move up, your long leg covers the loss on
your short leg and visa versa if markets move down.

Unfortunately, partially due to secrecy(trying to hide what they were doing)
and partially due to just who had the bond inventory to short from, they often
ended up having the long leg and the sort leg at two different banks.

So to LTCM they were perfectly hedged, while to the bank with the short
positions, if the market went up they needed LTCM to send them more margin. So
LTCM, which was already heavily leveraged was required to send their prime
brokers margin that they never figured they'd need to.

Couple that with markets that started move in an unprecedented manner caused
too many of their spreads to diverge beyond what they could cover.

The firm ends up getting a margin call it can't afford, liquidates everything
to its prime brokers and other investment banks and those banks end up making
money off their trades in a time frame from 6 months (for Goldman) to 3 years
for the longer term bonds.

Even when your models are right the market can still rip you to shreds:(

 __EDIT __As to book recommendations below is a picture of my work bookshelf.
Id ' recommend most of the books on the shelf:
[https://imgur.com/OdzB4aW](https://imgur.com/OdzB4aW)

[https://imgur.com/zdLSEek](https://imgur.com/zdLSEek)

~~~
henrik_w
Thanks for the book recommendations! As a SW dev who recently (a year and a
half ago) moved into finance (from telecom), I’ve been trying to educate
myself as much as possible in the domain - I find it quite fascinating. Below
is a list of books I’ve read and MOOCs I’ve taken, but it would be great to
hear what your top recommendations are for books to read (I’ve noticed that
your high-quality comments here on HN). Thanks.

Books:

Liar’s Poker, The Quants, Flash Boys, Against the Gods, The Complete Guide to
Capital Markets for Quantitative Professionals

MOOC courses: Financial Markets (Coursera), Computational Investing
(Coursera), Mathematical Methods for Quantitative, Option Pricing (EdEx - got
too difficult at the end)

EDIT: Thanks for the pics, really great! Lots of good CS books there too!
Sidenode: I just finished "Ghost in the Wires" a week ago - great read.

My bookshelf is shown here: [http://henrikwarne.com/2015/04/16/lessons-
learned-in-softwar...](http://henrikwarne.com/2015/04/16/lessons-learned-in-
software-development/)

~~~
osullivj
Frank Partnoy's FIASCO, Das' Traders, Guns & Money. Also Victor Niederhoffer's
Education of a Speculator.

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sharemywin
This reminds me of doubling down in a casino. If you keep double your bet on a
~50/50 bet you will cover your previous losses when you win. Until you run out
of money because you come across the string of losses that breaks you. And
when that happens your loss is huge. x+2x+4x+8x etc.

~~~
Pete_D
This is also known as a martingale strategy.

[https://en.wikipedia.org/wiki/Martingale_(betting_system)](https://en.wikipedia.org/wiki/Martingale_\(betting_system\))

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snake_plissken
Hah I just read "When Genius Failed" after finding it at my parents house over
Thanksgiving. I'd known about LTCM, it's a case study in 2nd year classes in
political economy/finance, and the book is a nice account of things.

LTCM's problem wasn't the BSM per-se, it was the fact that they went chasing
after trading opportunities once the arbitrage space in bond/swap spreads had
been, ironically, arbitraged away. In the process of doing this they leveraged
themselves to the hilt and basically ran out of cash defending the positions.

~~~
lintiness
a function of greed, not competition. if we can put up x% returns forever no
matter what, why not add and add and add. they were believers, and with
certainty comes danger.

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CapitalistCartr
" . . . the formula’s publication in 1973. Within several years, the formula
came standard on the calculators held by every options trader."

What calculators would that be in the late Seventies?

~~~
wpietri
And by the 90s, I don't remember traders ever picking up a calculator, or even
seeing one around the office with finance-specific stuff. I was at a small,
tech-focused firm, so maybe it was different elsewhere, but I was surprised to
read this.

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mynegation
To summarize: "Markets can stay irrational longer than you can stay solvent".
Reversion to the mean that was fast during Black Monday turned out to be much
longer for 1997 Asian financial crisis.

