Derivatives Models on Models

15

Hidden Conditions and Coin Flip Blow Up's^*

1 Blowing Up

I will now take a quick look at the danger of ignoring hidden conditions in quantitative finance. How many times have we heard about traders, hedge funds and trading desks being surprised by sudden unexpected massive losses? I am not speaking only about inexperienced traders, for some of the most talented people in this field have lost their shirts. The LTCM blow up with Meriwether and his team, including Nobel prize winners Scholes and Merton, offers only one example. Personally, I was lucky enough to burn a considerable amount of my own wealth at an early age, so let's start with the inexperienced trader blowing up. Fortunately, my net wealth was also very low at that time, so despite the large percentage losses, the dollar amount did not make the press, until now. In 1986 I was studying garden plants at a university in southern Norway, and in-between classes I would go out to the phone booth and call my stock broker. As this was before the internet and cell phones were commonplace, an old-time coin phone booth was my only weapon. By mid 1987 I had made fantastic returns simply by flipping in and out of long stock positions, and I of course felt like the master of the universe. Soon my small savings that I had originally saved up from hard physical work at my grandmother's farm blossomed into a money tree that simply had to be watered daily and would grow predictably, and I planned to cash it in soon and buy a red sports ...