Financial Engineering vs Monetary System of Production

["John Gelles" <jjgelles@xxxxxxxx>]

        PBS NOVA series last night presented the Long
        Term Capital Management and Black-Scholes
        option pricing stories in their episode called,
        "The Trillion Dollar Bet: The Formula that Shook
        the World".

        Below this message is a tiny extract of their web
        version of the presentation (as a teaser). The
        presentation is available at   http://www.pbs.org

        The gist of these stories is that past price data
        may offer patterns, but these do not define the
        limits of future patterns. If you are "doubling" your
        bets on a return to a past pattern, know when to
        quit, because you may easily need to risk more
        capital to keep "doubling" than you can find on
        favorable terms.
                ("Doubling" is a metaphor here for taking
        large positions with borrowed money when
        trading in markets that resemble casinos.)

        Knowing when to quit will presumeably allow a
        "financial engineer" with "good trading judgement"
        to apply mathematical models to real markets and
        earn money without risk -- until something outside
        the scope of the model happens.
                At that point the "wise engineer" quits his
        positions, takes his loss (preseumeably affordable),
        and waits a while before going back into the same
        or similar markets, (no longer acting perversely),
        with the same of a better set of models.

        Assuming the markets we are playing in without
        risk are the same that others use in a monetary
        system of essential production, what is the
        connection between financial engineering and
        responsibile economic planning -- if any?

        Economic planners at the top echelon of the
        system must avoid hyperinflation and depression;
        and presumeably there is a risk of both at all
        times. (We should assume that hyperinflation
        leads to depression and depression leads to
        totalitarian police state government.)

        One character in the above stories likens a
        financial engineering operation to a giant
        vacuum cleaner scouring the markets of the
        world sucking up nickels. Profits on the
        spread between what you buy and what
        you sell are very small, but the volume of
        trade is very large. The risk for a time is zero.
        Or so some of the players claim for their
        models -- and some times series experts
        agree, especially those who know Ito
        calculus for dynamic calculation of change.

        In economic planning we also claim the risk
        is zero for the time between a starting date
        and an unforseen catastrophe that destroys
        resources, region, continent or planet.

        We claim we can always print more money
        to end deflation and tax more money (or other-
        wise take it out of play) to end inflation.

        The law has shaped opportunity for financial
        engineering. Black-Scholes remains in business,
        so too are the principals who once ran Long
        Term Capital Management.

        But the law today takes a dim view of economic
        planning of the type that wins wars.  Industrial
        policy, Japan Inc., and all such planning within
        competitive market systems is substantially less
        intense than full employment, social and
        environmental engineering would call for --
        if in peacetime we miimicked what wins wars.

        So financial engineering as a profession that
        supports econometricians (with wisdom enough
        to quit positions from time to time);  while those
        who write policy for economic planning remain
        locked in battle at the level of ideology.

        Many, of course, make a good living out of that
        battle -- especially if they support the rich or
        write well enough to appeal to a mass audience.

        Will Nova do a series on the future of economic
        planning?  Will they scour the world for policies
        whose implementation has reduced the risk of
        poverty and pollution among the people who
        enacted laws reflecting them? Perhaps a story
        from Denmark, Finland or somewhere, where
        risk free casinos are not relied on to put food
        on the table and shoes on your feet?

        They will, if PKT writes a proposal that is at
        all rational. One that might presage winning
        the Nobel prize.

            John Gelles


            ----------------------------------------------
            Extracted from PBS.org Site, NOVA Series:

The Trillion Dollar Bet The Formula that Shook The World

Let's not kid ourselves: The Black-Scholes option-pricing formula is a
difficult concept to grasp. To begin to understand the explanation of the
formula below, you might want to first review the section on call options.
Then click on the formula itself for definitions of its various elements.
Finally, have a look below at the theory behind the formula. For a more
comprehensive explanation of the formula, we recommend Chapter 20 of
Investments, by Zvi Bodie, Alex Kane, and Alan Marcus (Irwin Press, 1996),
and Finance, by Zvi Bodie and Robert Merton (Prentice Hall, 2000), the
primary sources for this article.

                            Theory behind the formula

Derived by economists Myron Scholes, Robert Merton, and the late Fischer
Black, the Black-Scholes Formula is a way to determine how much a call
option is worth at any given time. The economist Zvi Bodie likens the impact
of its discovery, which earned Scholes and Merton the 1997 Nobel Prize in
Economics, to that of the discovery of the structure of DNA.

Both gave birth to new fields of immense practical importance: genetic
engineering on the one hand and, on the other, financial engineering.

The latter relies on risk-management strategies, such as the use of the
Black-Scholes formula, to reduce our vulnerability to the financial
insecurity generated by a rapidly changing global economy.

Here's the theory behind the formula: When a call option on a stock expires,
its value is either zero (if the stock price is less than the exercise
price) or the difference between the stock price and the exercise price of
the option. For example, say you buy a call option on XYZ stock with an
exercise price of $100. If at the option's expiration date the price of XYZ
stock is less than $100, the option is worthless. If, however, the stock
price is greater than $100 -- say $120, then the call option is worth $20.
The higher the stock price, the more the option is worth. The difference
between the stock price and the exercise price is the "payoff" to the call
option.

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. To understand
this, consider our example of XYZ stock. Suppose that instead of owning the
call option, you purchased a share of XYZ stock itself and borrowed the $100
exercise price. At the option's expiration date, you sell the stock for
$120, you pay back the $100 loan, and you are left with the $20 difference
less the interest on the loan. Note that at any price above the $100
exercise price, this equivalence exists between the payoff from the call
option and the payoff from the so-called "replicating portfolio."

But what about before the call option expires? Believe it or not, you can
still match its future payoff by creating a replicating portfolio. However,
to do so you must buy a fraction of a share of the stock and borrow a
fraction of the exercise price. How do you know what these fractions are?

That is what the Black-Scholes Formula tells you.
It states that the price of the call option, C, is equal to a fraction --
N(d1) -- of the stock's current price, S, minus a fraction --  -- of the
exercise price. The fractions depend on five factors, four of which are
directly observable. They are: the price of the stock; the exercise price of
the option; the risk-free interest rate (the annualized, continuously
compounded rate on a safe asset with the same maturity as the option); and
the time to maturity of the option. The only unobservable is the volatility
of the underlying stock price.

If the current stock price is way above the exercise price, these fractions
are close to 1, and therefore the call option is approximately the
difference between the stock's current price and the present discounted
value of the exercise price. If, on the other hand, the current stock price
is way below the exercise price, these fractions are close to zero, making
the value of the call option very low.

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