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The
Merchants of Greenwich
By William
Bernstein, Efficient
Frontier
Aside from my Simpsons
addiction I don't watch much television. But when a friend called
me up one evening and told me to catch the PBS/Nova documentary
"The Trillion Dollar Bet" I knew I wasn't going to be disappointed.
After all, it's not every day that you get an hour's face time with
the likes of Paul Samuelson, Myron Scholes, Zvi Bodie, Roger Lowenstein,
Robert Merton, and Merton Miller and their respective versions of
the 1998 near-Gotterdammerung of the world's economy-the Long Term
Capital Management debacle.
If you've not seen this
superb program I urge you to seek out a rebroadcast, or even
purchase the tape (1-800-949-8670 x498). It's no exaggeration that
anyone with an interest in the capital markets will find this production
lush and hypnotic-an exquisitely produced Shakespearean tale of
hubris and humiliation.
The producers deftly
explore the history of the efficient market hypothesis, the Black-Scholes
equation (the image shown below the title) and subsequent birth
of the modern options market, which in turn gave rise to LTCM's
basic strategy-placing tens of thousands of small derivatives bets
that the historical relationships among global asset class prices
would eventually mean-revert. So if, say, the gap between the price
of Danish Mortgage options and the mark/yen swap got significantly
larger than its historical average, the appropriate positions would
be taken to profit from the move back to equilibrium.
As the hour wore on,
the question repeatedly arose; what's wrong with this picture? How
did the financial world's best and brightest screw up so badly?
The answer, I think, lies in this unobtrusive observation from one
of the LTCM principals:
In August 1998
after the Russian default all the relations that tended to exist
in the recent past seemed to disappear.
One can almost imagine
these folks glumly sitting around an oak-paneled room, slapping their
collective foreheads and exclaiming; "Jeez, we've never seen the markets
do that before!" However, even a cursory reading of financial
history shows that markets behave in unique, never-before-seen ways
on a remarkably frequent basis. In fact, it's astonishing that this
group of brilliant financial economists seemed oblivious to the fact
that even the longest statistically well-behaved series of securities
and asset class returns and correlations can radically change character
in a heartbeat. In short, they forgot Newton's rueful admission, prompted
by losing a fortune in the South Sea Bubble, that although he could
precisely calculate the motions of the heavenly bodies, he could not
predict the madness of crowds.
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