central punters

Michael Cohen mike at cns.bu.edu
Mon Oct 5 09:19:43 PDT 1998

Brad De Long wrote:

> It may be that LTCM's strategy was fundamentally sound, but
> undercapitalized given the amount of "noise" in the market these days
> (that's what Robert Merton argued was the case when Metallgesellschaft got
> into trouble, and I presume that's what he's arguing now). And to the
> extent that LTCM's new owners buy this argument, expect them to continue
> the strategy rather than to try to unwind the positions.

Indeed this is possible but silly. The major technical difficulty, as opposing substantive difficulty, which are enormous, with Black Scholes like theory it is highly likely that risk i.e. the variance of the return is improperly estimated. Standard theory and time scaling has as a consequence that risk can be estimated with probability one, on markets as the time sequences of the markets is recorded at shorter and shorter intervals, a patent absurdity. Incidently this is true of real Brownian Motion, not markets, so we do have good and reliable estimates of temperature variation in heat baths. We also can obtain confidence bars for our estimates, something probably near impossible in economics. Presumably, even if the LTCM return is "sufficiently high" i.e. sound from the standpoint of expected return, if the risk is sufficiciently high investment is a waste of time. About equally likely then as a positive return is gamblers ruin.

Krugman I think made the correct point that if with probability (1+epsilon) one became fantastically wealthy and with probability (1-epsilson) one gets bailed out by the state then one might be willing to take the risk, especially if you are a bourgeois who has no concern for the stability of the sytem. Presumably, if Meriwether, Merton en company had to work on a chain gang to pay their bills to their creditors or even if they were were required to work at minimum wage for their creditors until they made them they money that was lost, they never would have assumed the risk.

--mike -- Michael Cohen mike at cns.bu.edu Work: 677 Beacon, Street, Rm313 Boston, Mass 02115 Home: 25 Stearns Rd, #3 Brookline, Mass 02146 Tel-Work: 617-353-9484 Tel-Home:617-734-8828 Tel-FAX:617-353-7755

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