The Midas Formula. Horizon (2nd December 1999), BBC2, 9:30pm
Trillion Dollar Bet. NOVA (February 8, 2000), PBS
This documentary tells us the story of Long Term Capital Management, a hedge fund that spectacularly failed in September 1998.
It starts with a description of the stock exchange and the classic psychological view of the markets, as held by traders: Fearful people sell, greedy people buy securities. In this view, the market is based purely on irrational emotions. So, if a good trader succeeds to do a correct psychoanalysis of the public opinion, using his own intuition as an experienced trader, he can predict how the market will move and thus beat the market. This view is immediately contrasted with the academics' view that there is not really any method to predict in the movements of the market, because it is a random walk. As an argument, the experiment of throwing darts at the Wall Street Journal and buying this random sample of stocks is given. The outcome was that it outperformed even the top traders.
Then, Louis Bachalier's dissertation and his presentation of option contracts is described. We are introducted to the question of how to price these options, given that the market moves randomly. We see a lot of attempts to solve the issue by adding factors to the equation that are basically just the psychological notions that are used by the traders.
We have a nice look at the development of the Black–Scholes formula: First, all these ad-hoc additions of psychological notions in the existing formulas were removed completely, with only the risk factor being left as the last unknown. We learn that the crucial idea is to build a portfolio of stocks and options in such a way that they cancel out each other's movements, with adjustments in regular intervals (“dynamic hedging”). This makes it possible to eliminate the risk factor, and it is then trivial to find out the true price of the option contract. A final ingredient to the complete formula is the addition of continuous time, which allows to change from regular adjustements to continuous adjustments.
We are told that the traders immediately started to use the formula for trading, even before it was officially published. We are given an impression of the many things that are now possible: Everything can be hedged against almost everything else, reducing risks. A trader even claims that this means that the more trading takes place, the better off the society is, because allegedly the less risk there is.
The formula finally earned their inventors the nobel price. We see how shortly after, Long Term Capital Management, a hedge fund, was founded by the nobel prize winners. We learn a little bit about the strategies it was using and how big a success it was initially. But then, we see the fund collapse spectacularly, because of its ever increasing leverage, which it needed to hedge the fund against losses caused by some unexpected events. The fund had gambled with a total of 1 trillion dollar, about 97% of which were debts. We see the liquidation of the fund, which is painful for its founders both in terms of loss of public reputation and in terms of loss of their own money, which they had invested into the fund.
The documentary closes with a statement by a trader and by an academic, implying that, in the end, the trader's way of tackling things with common sense and intuitions is superior to the academics' way of tackling them with mathematical formulas.
I think that the documentary's introduction into some key aspects of finance (Option contracts, Louis Bachelier's work, the efficient market hypothesis and the classic views of traders versus academics, the Black–Scholes formula, LTCM's founding and finally its downfall) is very good. It is done simple enough to be understandable for the layman, yet preserves the core ideas without distortion. Throughout the documentary, the academics' view is defended by the economists Myron Scholes, Merton Miller, Paul Samuelson and Zvi Bodie and the traders' view by Ben Schwartz, Leo Melamed and Stan Jonas. Last but not least, the music that underlines the story generates just the right mood.
There are some differences between the PBS and the BBC version. The PBS one, although broadcasted later, seems to have been done earlier, because it is more detailed about many things, while the BBC version sacrifices that precision for better general public understandability. Also the music and the story told by the narrator, although clearly similar, seem have been improved for a better flow in the BBC version.
There is a very good discussion of the LTCM case by Warren Buffett in his University of Florida talk which I can only fully agree with: It is fascinating to see people so intelligent operating in their own area of expertise with virtually all of their own money invested still going broke. "They are not bad people at all. But—To make money they didn't have and didn't need, they risked what they did have and did need ... and that's just plain foolish [...] If you risk something that is important to you for something that is unimportant to you, it just does not make any sense."