Then, in 1997, the Royal Swedish Academy of Sciences awarded the prize to Robert Merton and Myron Scholes for their option pricing formula. I (and many traders) find the prize offensive: many, such as the mathematician and trader Ed Thorp, used a more realistic approach to the formula years before. What Mr Merton and Mr Scholes did was to make it compatible with financial economic theory, by “re-deriving” it assuming “dynamic hedging ”, a method of continuous adjustment of portfolios by buying and selling securities in response to price variations.
Dynamic hedging assumes no jumps – it fails miserably in all markets and did so catastrophically in 1987 (failures textbooks do not like to mention).
Later, Robert Engle received the prize for “Arch ”, a complicated method of prediction of volatility that does not predict better than simple rules – it was “successful” academically, even though it underperformed simple volatility forecasts that my colleagues and I used to make a living.
The environment in financial economics is reminiscent of medieval medicine, which refused to incorporate the observations and experiences of the plebeian barbers and surgeons. Medicine used to kill more patients than it saved – just as financial economics endangers the system by creating, not reducing, risk. But how did financial economics take on the appearance of a science? Not by experiments (perhaps the only true scientist who got the prize was Daniel Kahneman , who happens to be a psychologist, not an economist). It did so by drowning us in mathematics with abstract “theorems”. Prof Merton’s book Continuous Time Finance contains 339 mentions of the word “theorem” (or equivalent). An average physics book of the same length has 25 such mentions. Yet while economic models, it has been shown, work hardly better than random guesses or the intuition of cab drivers, physics can predict a wide range of phenomena with a tenth decimal precision.
Every time I have questioned these methods I have been abruptly countered with: “they have the Nobel”, which I have found impossible to argue with. There are even practitioner associations such as the International Association of Financial Engineers partaking of the cover-up and promoting this pseudo-science among financial institutions. The knowledge and risk awareness we are accumulating from the current subprime crisis and its aftermath will most certainly not make it to business schools. The previous dozen crises and experiences did not do so. It will be dying with us, unless we discredit that absurd Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel commonly called the “Nobel Prize”.
The Ed Thorp he mentions is the same Ed Thorp who figured out how to win at blackjack in casinos by counting cards.
Thorp was one of the first seven inductees chosen to the Blackjack Hall of Fame.
The mathematician who could model risk effectively got into the Blackjack Hall of Fame while the duffers who could not won the Nobel Prize for Economics.
Most of you readers are not in the Blackjack Hall of Fame but at least you have not won the Noble Prize for Economics, and that has to count for something.
This paper that explains how options trading works in practice is fascinating.