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Before Black-Scholes gets bashed too hard, people should keep in mind that it's nearly 50 years old. Of course it's going to be outdated and inaccurate (as all

Before Black-Scholes gets bashed too hard, people should keep in mind that it's nearly 50 years old. Of course it's going to be outdated and inaccurate (as all models are). It's worth reflecting on what options markets were like before Black-Scholes: a lot smaller and valued through qualitative, "over-the-counter" measures. More like handshake one-off business deals than liquid markets. Regardless of how you feel about options trading or the role of liquidity in financial markets, Black-Scholes was an intellectual achievement and should be remembered as such, even as newer better techniques replace it. To his credit, Ed Thorp also realized this at the same time as Black-Scholes but chose the money-management route and didn't feel the need to publish his strategies as papers for the academic community (and probably giving up the Nobel Prize in Economics). My two favorite books on these people are Perry Mehrling's biography of Black and Ed Thorp's autobiography. Fischer Black: https://www.amazon.com/Fischer-Black-Revolutionary-Idea-Finance/dp/0471457329/ https://www.amazon.com/Fischer-Black-Revolutionary-Idea-Fina... Ed Thorp: https://www.amazon.com/Man-All-Markets-Street-Dealer/dp/0812979907/ https://www.amazon.com/Man-All-Markets-Street-Dealer/dp/0812...

viburnum 7y ago
There’s an excellent book called “An Engine, Not a Camera: How Financial Models Shape Markets” that lives up to its title.
camjohnson26 7y ago
Myron Scholes was heavily involved in LTCM, a hedge fund whose strategy was to apply statistical models to trading. It was one of the most spectacular business failures of the last few decades, losing $4.5 billion in value. https://en.m.wikipedia.org/wiki/Long-Term_Capital_Management https://en.m.wikipedia.org/wiki/Long-Term_Capital_Management
- cheez 7y ago
  In their defense, they were fine until they stopped paying attention to risk and correlated positions. So this isn't a knock on the BS model necessarily, but human greed.
  - yellowstuff 7y ago
    It's true that they were very profitable for several years, and then lost a ton of money at the end. Some of their worst losses were due to "style drift" into strategies that they were not experienced in, such as an unhedged bet on the Russian ruble before it was devalued. However, their core strategies involved exploiting very small profits with 25X leverage. Very few strategies can survive with that much leverage. Obviously a 4% decline in asset prices wipes you out, but in the case of LTCM it didn't take that large of a move. Since they were large and well-known when they started to lose money other traders figured out their positions and bet against their specific positions, knowing that LTCM would be forced to sell. This is all from the excellent book "When Genius Failed."
    - cheez 7y ago
      Also true
    - MR4D 7y ago
      “How did you go bankrupt? Two ways. Gradually and then suddenly.”
- agar 7y ago
  Losing $4.5B in value really understates the impact LTCM's failure had on the public markets. Multiple wall street firms (at US Government urging) needed to urgently inject massive capital into the markets to contain a near-systemic collapse. PBS produced a phenomenal documentary, The Trillion Dollar Bet[1], which covers the development of Black-Scholes and the rise and fall of LTCM. Highly recommended. [1] http://watchdocumentaries.com/trillion-dollar-bet/ http://watchdocumentaries.com/trillion-dollar-bet/
- navigatesol 7y ago
  >It was one of the most spectacular business failures of the last few decades, losing $4.5 billion in value. How quaint. In 2019, tech companies burn through billions of dollars of capital every single year, and we call them business "successes".
  - throwaway66920 7y ago
    While there’s lots to complain about this practice, those aren’t really the same thing. Tech firms are losing cash but generally gaining value towards an IPO. Whereas the investments were simply losing value.
    - Supermancho 7y ago
      > It was one of the most spectacular business failures of the last few decades, losing $4.5 billion in value. > Tech firms are losing cash but generally gaining value towards an IPO. ...but they don't always. This makes the original statement sensationalist nonsense as it's happened multiple times (over the time period mentioned). Valuation is screwed up in both "types" of businesses, but the methodology is irrelevant to the claim when it's apples to apples for the market.
  - georgeecollins 7y ago
    But the government hasn't yet needed to bail out a VC, a Unicorn or a stockholder. Each may lose money, but that happens all the time. In the case of LTCM the government needed to bail out LTCM positions. That is why it is different.
    - roenxi 7y ago
      Although true, the money that the tech companies are burning through is probably related to the bail-out money that the trading firms are getting. The banks keep dealing with high levels of leverage. It keeps predictably blowing up in their faces. The government/Federal Reserve is responding by making it easier to borrow money and then VC/Unicorns etc borrow. The links aren't perfectly causal, but I bet that under normal conditions (if interest rates were allowed to rise into the 2-6% band in a sustained way and the government stopped handing out free money) then suddenly the unicorns would be subjected to market logic such as a need to make money to receive a high valuation.
cm2187 7y ago
Even more modern models like SABR got broken by negative rates and the quants adjusted in the same way, they just shifted it.
SilasX 7y ago
>Before Black-Scholes gets bashed too hard, people should keep in mind that it's nearly 50 years old. Of course it's going to be outdated and inaccurate (as all models are). But the part about money having a positive time value shouldn't be. That indicates a major problem in the system.

viburnum 7y ago

There’s an excellent book called “An Engine, Not a Camera: How Financial Models Shape Markets” that lives up to its title.

camjohnson26 7y ago

Myron Scholes was heavily involved in LTCM, a hedge fund whose strategy was to apply statistical models to trading. It was one of the most spectacular business failures of the last few decades, losing $4.5 billion in value. https://en.m.wikipedia.org/wiki/Long-Term_Capital_Management https://en.m.wikipedia.org/wiki/Long-Term_Capital_Management

cheez 7y ago
In their defense, they were fine until they stopped paying attention to risk and correlated positions. So this isn't a knock on the BS model necessarily, but human greed.
- yellowstuff 7y ago
  It's true that they were very profitable for several years, and then lost a ton of money at the end. Some of their worst losses were due to "style drift" into strategies that they were not experienced in, such as an unhedged bet on the Russian ruble before it was devalued. However, their core strategies involved exploiting very small profits with 25X leverage. Very few strategies can survive with that much leverage. Obviously a 4% decline in asset prices wipes you out, but in the case of LTCM it didn't take that large of a move. Since they were large and well-known when they started to lose money other traders figured out their positions and bet against their specific positions, knowing that LTCM would be forced to sell. This is all from the excellent book "When Genius Failed."
  - cheez 7y ago
    Also true
  - MR4D 7y ago
    “How did you go bankrupt? Two ways. Gradually and then suddenly.”
agar 7y ago
Losing $4.5B in value really understates the impact LTCM's failure had on the public markets. Multiple wall street firms (at US Government urging) needed to urgently inject massive capital into the markets to contain a near-systemic collapse. PBS produced a phenomenal documentary, The Trillion Dollar Bet[1], which covers the development of Black-Scholes and the rise and fall of LTCM. Highly recommended. [1] http://watchdocumentaries.com/trillion-dollar-bet/ http://watchdocumentaries.com/trillion-dollar-bet/
navigatesol 7y ago
>It was one of the most spectacular business failures of the last few decades, losing $4.5 billion in value. How quaint. In 2019, tech companies burn through billions of dollars of capital every single year, and we call them business "successes".
- throwaway66920 7y ago
  While there’s lots to complain about this practice, those aren’t really the same thing. Tech firms are losing cash but generally gaining value towards an IPO. Whereas the investments were simply losing value.
  - Supermancho 7y ago
    > It was one of the most spectacular business failures of the last few decades, losing $4.5 billion in value. > Tech firms are losing cash but generally gaining value towards an IPO. ...but they don't always. This makes the original statement sensationalist nonsense as it's happened multiple times (over the time period mentioned). Valuation is screwed up in both "types" of businesses, but the methodology is irrelevant to the claim when it's apples to apples for the market.
- georgeecollins 7y ago
  But the government hasn't yet needed to bail out a VC, a Unicorn or a stockholder. Each may lose money, but that happens all the time. In the case of LTCM the government needed to bail out LTCM positions. That is why it is different.
  - roenxi 7y ago
    Although true, the money that the tech companies are burning through is probably related to the bail-out money that the trading firms are getting. The banks keep dealing with high levels of leverage. It keeps predictably blowing up in their faces. The government/Federal Reserve is responding by making it easier to borrow money and then VC/Unicorns etc borrow. The links aren't perfectly causal, but I bet that under normal conditions (if interest rates were allowed to rise into the 2-6% band in a sustained way and the government stopped handing out free money) then suddenly the unicorns would be subjected to market logic such as a need to make money to receive a high valuation.

cm2187 7y ago

Even more modern models like SABR got broken by negative rates and the quants adjusted in the same way, they just shifted it.

SilasX 7y ago

>Before Black-Scholes gets bashed too hard, people should keep in mind that it's nearly 50 years old. Of course it's going to be outdated and inaccurate (as all models are). But the part about money having a positive time value shouldn't be. That indicates a major problem in the system.