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October 21, 1998 Richard Olsen knows why LTCM went wrong : The Black & Scholes model doesn't reflect markets behavior. |
There are always market pundits who claim they had warned early on that a bear market was in sight, but Richard Olsen is of a different kind. Here's a rocket scientist who saw the disaster coming in something most in the financial world don't understand even now after it has gotten so much press.
He
has been very critical for years
Richard Olsen, 45, founder and CEO of Olsen & Associates in Zurich, has
been one of the early physicists to develop an interest in high frequency quantitative
analysis of the currency market. OK, that's boring and sounds just as suspicious
as LTCM. But the interesting fact is that Richard Olsen has been very critical
for years about the Black & Scholes model which brought all this mess by
blowing off the highest scientifically molded derivative strategies. "The
Black & Scholes model, which serves as a reference for all options markets,
is wrong", Richard Olsen declared as early as October 1994 in an interview
with the French business magazine L'Expansion, an equivalent of Fortune magazine
in France and one of the first mainstream publications to recognise Olsen's
breakthrough. He also repeatedly expressed his concerns in publications such
as Finance and Stochastics, The European Journal of Finance or the International
Bond Investor, a Euromoney publication.
Olsen's remark is bold but obvious, even for a neophyte. "The problem is not the valuation model itself, observes Richard Olsen, but the fact that it takes a wrong assumption of markets behavior." The Black & Scholes model actually considers that market prices and volatility evolve according to a standard normal statistical distribution, which is the Gaussian law we studied in college. "This model assumes that an extreme volatility can roughly be four times higher than the normal one, contends Richard Olsen. But in the real world, extreme volatility can go ten or twelve times higher than the normal." This little flaw can trigger huge repercussions, as LTCM collapse revealed. "LTCM losses can already be much higher than we suspect, says Olsen. But the scale of the casualties caused by using the wrong assumptions can be enormous all across the derivatives markets." Who's next?