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Strategies & Market Trends : Roger's 1998 Short Picks -- Ignore unavailable to you. Want to Upgrade?

To: Eric Klein who wrote (14527)	10/9/1998 7:04:00 PM
From: BelowTheCrowd	Read Replies (1) \| Respond to of 18691

Yup, the essential truth to Black/Scholes and Merton/Scholes is that they provide the best possible pricing mechanism for derivatives, factoring in all known data about volatility in the underlying asset. The problem is that when volatility changes rapidly, the formulas break down. This is true whether it is a significant increase in volatility (as we have had lately) or a significant decrease. In the former case they'll underestimate risk, in the latter they'll overestimate. mg

To: Eric Klein who wrote (14527)	10/12/1998 8:50:00 PM
From: Ajay	Read Replies (1) \| Respond to of 18691

Regarding LTCM, I'm finishing up at UofC and have studied Scholes' work. Being somewhat familiar, my thinking is that they relied on the historical spreads between bonds. for example, given the spread of a 30 year with 27 yrs left vs a newly issued one. Normally the spread narrows and the group can make 40-60 basis points per dollar. Not a great return unless you leverage it 30:1. But the flight to quality got so bad that nobody wanted any of the bonds except the newly issued ones driving the yield completely out of whack. No global crisis scenario built into any of their risk exposure models. the sad thing is the financial firms that were basically groping over each other to lend them money - most with no collateral. Egos will ruin the brightest.