The Money Formula

CHAPTER 4Market Makers

“There is a theory which states that if ever anybody discovers exactly what the Universe is for and why it is here, it will instantly disappear and be replaced by something even more bizarre and inexplicable. There is another theory which states that this has already happened.”

—Douglas Adams, The Original Hitchhiker Radio Scripts

“Money is, to most people, a serious thing. They expect financial architecture to reflect this quality – to be somber and serious, never light or frivolous. The same, it may be added, is true of bankers. Doctors, though life itself is in their hand, may be amusing. In Decline and Fall Evelyn Waugh even has one who is deeply inebriated. A funny banker is inconceivable. Not even Waugh could make plausible a drunken banker.”

—John Kenneth Galbraith, Money: Whence It Came, Where It Went

One of the most basic of financial instruments is the option. This is a contract or agreement which gives you the option (but not the obligation) to buy or sell something in the future at a certain price. Even a coin can be considered as an option to purchase government services, or pay taxes – if we don't want to keep the option, then we can melt the coin down, which people sometimes do when the cost of the metal exceeds the value of the option. Despite the fact that options have been around for millennia, it was only in the 1970s that traders began to use mathematical models to price them. In this chapter, we show how mathematicians developed ...