Finance 450: Securities Analysis
“Trillion Dollar Bet”
List of Questions
The videotape you
will be watching is entitled, “Trillion Dollar Bet.” It describes the
development of the Black-Scholes (or Black-Scholes-Merton – the latter provided
a key piece for the final equation) option-pricing model, which was a key
development in theoretical finance and earned Nobel prizes for two of its
developers. But the model was not only a theoretical novelty; it also had great
practical importance and helped spur on the development of the market for
derivatives, which has since grown to over a trillion dollars. Merton and
Scholes were also interested in seeing the practical application of their
ideas, and the latter part of the videotape describes the story of Long Term
Capital Management (LTCM), a hedge fund in which Merton and Scholes were
partners and that grew to become the largest hedge fund in the world in the
late 1990s.
The following is a
list of questions regarding the material covered in the video. It is a long
list, including 25 (plus one) questions, but many of them can be answered with
a short “yes” or “no” answer or a short phrase (e.g., “rocket science”);
moreover, all of the questions, save for one, are listed in the same order in
which they are presented in the video (and the one that is out of order can be
answered using the information in the paragraph above). In order to get the
most out of the videotape, please review the questions before the class, then
answer them either as you watch the tape or shortly thereafter. The answers to
the questions will be due at the beginning of the following class period. Good
luck, and enjoy the movie!
Questions:
- What was the discovery that
revolutionized finance? What was the key insight about the relationship
between the risk of a stock and the risk of an option that allowed for
this discovery?
- What is the “golden rule” of finance and
capitalism?
- What would need to be done with regard
to risk in order to turn finance into a science?
- What is traded on the Chicago Mercantile
Exchange?
- In tests that financial economists
conducted in the years following the stock market crash of 1929, was it
possible to distinguish between skill and luck in terms of which is
responsible for the success of stock market investors?
- Who was the first person to come up with
the idea of using mathematical statistics to model movements in stock
prices (hint – he was French)?
- What is an option?
- Who were the three researchers who
finally figured out how to price options (hint – they are mentioned in the
first paragraph, above)?
- What feature of options made Myron
Scholes excited these investment instruments?
- What is dynamic hedging, what does it
involve, and why is it useful? (Note – this is probably the most difficult
question on this list.)
- What was the practical problem with
Black and Scholes’ equations?
- Who helped them to get around this
problem?
- To what field of study did he turn in
order to find a solution to this problem (hint – see the second paragraph,
above)?
- Did traders in the financial markets use
this formula, programming it into their calculators, or did they simply
ignore it as an academic model with no real-world value?
- Did this model require traders to trade
more frequently or less frequently in order to control or manage their
investment risks? What effect did this have on the size of the market for
“derivatives”?
- How big is the market for derivatives
today (hint – see the first paragraph, above, and think about the title of
the videotape)?
- What academic award did the developers
of the option-pricing theory receive for their efforts (hint – see the
first paragraph, above)?
- Were they rich at the time they received
this award? (Note – the reason I ask this question is in response to the
age-old question, “if you’re so smart, why aren’t you rich?” One
researcher, Paul Cootner of MIT, apparently irritated at having to answer
this inquiry so often, once replied to a money manager who had asked it of
him, “if you’re so rich, why aren’t you smart?”)
- Who is John Meriwether, and what is Long
Term Capital Management (LTCM)?
- Did LTCM have trouble raising capital to
start operations? What was their minimum required investment?
- How successful was LTCM during its first
three years? Was it equally successfully during its 4th year?
- The characteristics of the financial
markets changed in 1998 with the Asian currency crisis and the Russian
default. As a consequence of these events, how much did LTCM end up losing
in a single day, four days after the Russian default?
- What happened to LTCM as a further
consequence of these events?
- What drives financial markets? Do
mathematical equations drive financial markets?
- Was LTCM ultimately able to pay off its
debts?
- Final question: Based on the information
presented in this video, together with the material that has been covered
in class, would you categorize finance as an art, as a science, or as some
combination of the two? Why?