Derivative Pricing

According to BIS, there are some $420 trillion worth of outstanding derivative contracts as of 2007. Interestingly, the GDP of the rich man's club of G-7 countries is around $40 trillion. Theoretically, this means that any trouble in the global derivatives market, will make the recent sub-prime and mono-line insurance meltdown, look like child's play.

Michael Lewis quoting Nassim Nicholas Taleb says:
"In the past two years, Taleb has co-authored a pair of papers that have appeared in the sort of academic journals that originally published the Black-Scholes model. He and his co-author attack the model head-on in its own language (math), and as much as call for a retraction of the Nobel Prize awarded to Myron Scholes and Robert Merton for their work in creating the model. "This is what I'm saying to Merton and Scholes," Taleb says. "You guys are just parasites. You're not bringing anything useful to the market. You are lecturing birds on how to fly. You're watching them fly. And then you're taking credit for it."

The fundamental issue that is being raised is that the Black-Scholes model is inadequate for accurate pricing of risk and hence there is a possibility of extreme events testing the robustness of the global derivatives market.

Nassim Taleb's problem is not that his point of view is invalid. But having made his point, he refuses to move on. While it is possible that Black-Scholes may be inadequate or downright incorrect, the way forward is to build a new, better and robust model, which the industry can use with confidence.

To quote Sir Newton: "If I have seen further than other men, it is by standing upon the shoulders of giants."


For the complete article by Lewis see: Black-Scholes

Is $150 bn Deficit spending going to save the US economy ?

Bill Gross, says not completely.
"The $150 billion "return to sender" deficit plan advanced by Bush and the Congress, for instance, amounts to just 1% of GDP and is labeled temporary. It will be of marginal benefit to long-term prosperity. To understand why, consider that the productivity of our economy ultimately depends on its ability to 1) innovate, and 2) save and invest, and that there is little of either in this stimulus package. Some have even suggested – and with my somewhat grudging concession – that this package will help the Chinese economy more than ours. Americans will use the rebates to buy Chinese imports offered at Wal-Mart and the $150 billion will then wind its way inevitably back to Asian coffers."

Some interesting points:
1. The US Fed is caught between the Devil and the Abyss. If it cuts the interest rates, it incentivises the leveraged spending behavior of the American consumer which created the credit crisis in the first place and can lead to future price bubbles in other asset classes. Also a cut in the interest rates will force the Asian central banks and Gulf states, to evaluate the falling yields on their current dollar reserves and increase the incentive for diversification into alternate currencies like Euro, Pound etc.

2. On the other hand, if the Fed does not cut the rates, it will risk being accused of inaction during a period when economy is showing signs of a recession. 2008 being an election year in US, the pressure would be immense to salvage the economy. In addition, a full blown recession, of which there is an even chance according to the great (?) Greenspan, will test the so-called "Decoupling of Emerging Market's theory" to the fullest extent. With the increased correlation between financial markets across the world and the tangled web of leverage everywhere, it will not take long for the above theory to be tested, once US enters a recession.

3. Moral of the story - Damned if you do and damned if you don't !

4. So who is responsible for this mess? Reminds of a line from the movie Beowulf about "the sins of the fathers".


For the complete article by Bill Gross see: Better late than never

Introduction

Hi

This is a forum where the current and prospective students of OptionSwap can interact and discuss relevant issues in finance. I will also post from time to time, articles of interest that will be useful to students and general public.

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