Nobel prize? Pricing options correctly is hard but finding dumb “prizes” is easy. The 1997 award to Myron Scholes and Robert Merton and that is with the bar set very low in a dismal field that had no TRUE Nobel. The Black-Scholes “formula” has led to many problems for investors but is still used to misprice options. The Literature Nobel prize was more suitable for Scholes and Merton. Rarely has such fantasy and fiction had such impact.
Fake “Nobels” are yet more 1960s economics lunacy that must be put out of its misery. Anyone using stochastic calculus to “price” derivatives is wrong. But I am glad they exist so they can transmit their random negative alpha into my deterministic positive alpha. Win the zero sum game arbing “Nobel” equations.
It devalues legitimate Nobels to let such an error stand. As REPLACEMENTS and for their roles in demolishing the delusional dogma of efficient markets, I nominate hedge fund managers George Soros, Warren Buffett and James Simons. Each separately proved over long time periods using very different strategies, the falsity of always “correctly” valued securities.
Just one counterexample ends the random walk “debate”. Yes one consistently alpha generating suffices. Not that there was any debate among those investors with double or triple digit IQs. Only economics professors and index fund salesmen are stupid enough to claim markets are efficient. All products and pricing models dependent on “random” markets are unstable and unsuitable.
A heavy investor in hedge funds, the Nobel Endowment, wisely refuses to pay for a prize in oxymoronic economic “sciences” so Swedish taxpayers take the hit. Merton and Scholes are to financial engineering what the Titanic was to marine engineering. Neither would have gained tenure in the rigorous hard sciences but in soft economics they are superstars despite over 40 years of staggering wrongness.
The Swedish Central Bank, in conferring Nobel status on “economics”, devalues the work of Alfred Nobel, REAL scientists, writers and peacemakers. With rare exceptions, prizes have been awarded for either being completely wrong or stating the obvious and then having your academic buddies say how clever you are. Physicists, chemists and medics must endure decades of scrutiny and skepticism by many independent scientists yet economists have a laxer and in-bred peer “review” structure. To encourage such erroneous assumptions shows how structurally flawed the “discipline” is.
I’ve probably read every paper written by the “Nobel” dudes and they got little right. The mathematics is correct but the simplifications are silly and conclusions are crazy. Rational investors, random walks with drift, continuous time, constant volatility, lognormal distributions, geometric Brownian motion, heat diffusion in finance(?), stocks that move like gas molecules(??) – give me a break.
None of those assumptions has the remotest applicability to financial markets. Their work does NOT approximate how securities behave. There is no theoretical basis or empirical relevance of their work to derivatives pricing. Amazing such rubbish is still used. More problems ahead for anyone using models derived from Black Scholes.
The 1970s may be different to today but, even then, if you had REALLY come up with a way to price options accurately, would you publish OR would you use it to make money? Just because Black-Scholes and Merton’s work makes calculating option prices simple does not make it correct. Most of “Wall Street” uses models that can be traced back to it.
Being widely used does not ensure proof; all it guarantees is a LOT of people are wrong. Sure you can relax many of the assumptions and the “magic formula” still seems robust. Many would regard this as heresy but Black-Scholes and the “improvements” are useless for hedging and trading options. Incredibly some people are using Gaussian assumptions. Why?
I arbitraged those who used the “elegant” equation baed on absurd assumptions for years. My best quarter was summer 1998…LTCM. Try finding nickels in front of the steamroller and you will eventually be crushed. It is much better to be riding on the steamroller and crush such folks. The Long-Term Capital Management debacle was blamed on leverage, the Russian default and the trading team. While those had a role, LTCM was primarily a test of Scholes and Merton’s rational market theories. Short selling of options was the primary culprit based on their model showing volatility to be overvalued and misguided faith that security prices must “revert” to their idea of “correctness”.
If you short options you are short volatility; if volatility goes up you are quickly in trouble and the more the market moves against you the bigger your LOSING positions become. The more hedging you do, each time locking in a loss, pushes the market more against you especially if you are a big fund and massively short vol. There is less liquidity in options, especially long-dated ones and when marketmakers and other option liquidity providers sense oversized positions happily make it very difficult and expensive to cover that short vega exposure. Forcing LTCM into a vega short squeeze was not difficult for the market.
My options pricing model could not reconcile the cheapness at which LTCM was selling volatility swaps throughout 1997/1998. When turbulence hit they had no hope; the subsequent revelations of massive leverage were a reflection of the extreme shortness of vega that grew to dominate and devastate their portfolio. Leverage was always high but it turned into hyperleverage because they failed to understand the dangers. Long date vega gets illiquid when implied volatility rises sharply.
The family of Alfred Nobel are rightly opposed to an award for such “science”. Nobel himself was EXPLICIT in his will for the FIVE fields he wished to endow. But if the Economics Memorial prize must endure it is time the people who receive it actually merit it. For the anti hedge fund brigade it it worth noting that the Nobel Prize foundation considers true hedge funds to be safe securities. That is how they invest the endowment to award the REAL Nobel prizes.
SOURCE: Hedge fund – Read entire story here.