The Trillion Dollar Bet

The Trillion Dollar Bet

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The 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).

Bond -Stock Trading course: Learn about Bond -Stock Trading

Bond trading definition
Bond trading is one way of making profit from fluctuations in the value of corporate or government bonds.
Many view it as an essential part of a diversified trading portfolio, alongside stocks and cash.

A bond is a financial instrument that works by allowing individuals to loan cash to institutions such as governments or companies.
The institution will pay a defined interest rate on the investment for the duration of the bond, and then give the original sum back at the end of the loan’s term.

A stock trader or equity trader or share trader is a person or company involved in trading equity securities.
Stock traders may be an agent, hedger, arbitrageur, speculator, stockbroker.
Such equity trading in large publicly traded companies may be through a stock exchange.
Stock shares in smaller public companies may be bought and sold in over-the-counter (OTC) markets.

Stock traders can trade on their own account, called proprietary trading, or through an agent authorized to buy and sell on the owner’s behalf.
Trading through an agent is usually through a stockbroker. Agents are paid a commission for performing the trade.

Major stock exchanges have market makers who help limit price variation (volatility) by buying and selling a particular company’s shares on their own behalf and also on behalf of other clients.