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Built on genius, by legends of Wall Street and two Nobel laureates, it spiralled to ever greater heights, commanding unimaginable wealth. When it fell to earth in September it shook the world. This is the story of the rise and fall of LTCM and the legends behind it. A brave and ambitious work, Inventing Money was written by leading financial journalist Nicholas Dunbar.
Pages: Product dimensions: 6. During this period his interests ranged from quantum mechanics and black holes to evolution and the history of global climate change. In , Dunbar decided to leave academia. He spent the next few years working in feature films and television, in a wide range of capacities. In , after launching the television production company Flicker Films, a chance encounter with some old Harvard friends set him on a new path of finance and science writing, focusing on the derivatives industry.
In , he joined Risk magazine as technical editor. It was October and there was plenty going on to distract Fischer Black. Richard Nixon was on his way to winning the presidential election, and the country was bitterly divided over the Vietnam War, where almost a million US troops were in action.
Earlier that year, Martin Luther King had been assassinated, a bitter blow to those living in Boston's black ghetto of Roxbury. All over the world that year, riot shields confronted student banners. But Black had other things on his mind. A tall, quiet man with slicked-back hair and chunky spectacles, he wore a dark suit, in contrast to the long hair and afghan coats of the students leaving their classes. Black didn't notice the students; he was deep in thought as he entered the MIT economics faculty.
He was there at the invitation of a young Canadian academic, Myron Scholes, who had recently joined the faculty from Chicago. Aged 30, Black was earning a living at Boston consulting firm Arthur D.
Little, trying to advise mutual funds on their stock market investments. But Black's heart wasn't in his work. Instead, he was seeking Scholes's help in pricing an obscure type of financial contract called an option.
Black didn't yet know about the brainy youngstudent in the economics department, Robert C. Merton, who was interested in the same problem. A talkative year-old, Scholes showed his visitor into his office, and brought him a cup of coffee. He couldn't possibly know that the work he and Black were about to embark on would one day result in him and Merton shaking hands with the King of Sweden and accepting a Nobel Prize.
He would have been insulted by the suggestion that shortly afterwards, their activities at a hedge fund called LTCM Long-Term Capital Management would paralyse the global financial system. The two papers on the subject that the trio eventually published nearly five years later don't look too inspiring at first sight. Black and Scholes's opus was called 'On the pricing of options and other corporate liabilities' while Merton's paper rejoiced in the title of 'The rational theory of option pricing'.
Turn a few pages, and mathematical equations start dancing before one's eyes. Yet, although the ideas of Black, Scholes and Merton didn't have much immediate impact in , they eventually would change the world, along with the lives of their authors. Options would become vitally important to finance, but there was more to it than that. Black, Scholes and Merton had invented what came to be known as financial engineering. Just as the engineering of digital bits would eventually lead to the Internet, the mathematically driven engineering of stocks, bonds and other securities would create the modern trillion-dollar financial system.
Unlike the Internet, or the space shuttle, or any other engineering achievement, this one is largely invisible. Only when a disaster strikes, as would happen to Merton and Scholes and their colleagues at LTCM in , do people notice. The film opens with a stunning sequence where a prehistoric hominid hurls a bone spinning into the air, which becomes transformed into an orbiting space station. The story of finance is no different. When combined with mathematics and technology, the ancient urge to make money is amplified into a force of awesome power.
We can be sure of one thing. Markets arrived long before mathematics did. In fact, they go back to the distant origins of human behaviour, millions of years ago on the sweltering African savannah. Before we discover what Black, Scholes and Merton actually did, it's worth taking a brief excursion back in time to find out more.
The origin of trading In chimpanzee communities, individuals exchange gifts such as fruit or sexual favours within a group to cement alliances, and punish those who attempt to cheat on such mutually beneficial relationships. Anthropologists believe that early humans started trading in much the same way. The word they use to describe this behaviour is 'reciprocity' and our personal relationships work on this basis.
Helped by the gift of language, humans took trading far beyond the level of immediate family groups. Like chimps, humans have a xenophobic streak. Nevertheless, realising the advantage of specialising in the production of certain commodities, tribes that had once interacted purely to kill and enslave each other began exchanging goods through barter. Tribes that weren't interested in trading were either annihilated or forced to retreat to remote parts of the world where civilisations weren't viable.
As agricultural economies replaced nomadic ones, one-to-one trading gave way to markets. In a barter economy, cementing friendship is still a necessary part of exchanging goods. After all, if you needed to sell something, first you must look around for a partner who can offer you something worth while in return. Every barter trade is a unique, human event.
It depends intimately on time and place, as well as the personalities and histories of those who took part. To make a living purely through barter, you need a network of friends and acquaintances whose needs you understand.
All this changed when people started using money, which was first developed in the agricultural states of the ancient Middle East. Money establishes the meaning of a 'fair' price. If a complex, tortuous negotiation could be summarised by a simple cash value, then it could be compared with other deals at different times and places. The value of this information was quickly realised by governments, who could use it to collect taxes, and pay their armies and bureaucrats. For this reason, the use of money was associated with an increase in state power.
That wasn't completely a bad thing. With state power came the rule of law. In the old barter economy, the only way to punish fraud or cheating was to seek out the cheat in person, and claim damages. If the cheat had returned to the safety of his village, this might be impossible. Once legal codes came into existence, plaintiffs could appeal to state authority to enforce agreements.
In time, confidence in the law increased so much that legal agreements such as bills of receipt or share certificates became readily exchangeable for cash. We would now call these bits of paper a form of risk management.
In particular, shares were an important invention. Up to the seventeenth century, if you wanted to invest in a company, you had to join its owners in a partnership. If the company went bankrupt, you would be liable for its debts. But shares had something called 'limited liability', which protected investors from creditors. This very primitive form of financial engineering encouraged people to invest, and allowed economies to grow.
In a sense, the development of money and financial contracts was a democratic event. The knowledge of a fair price was hard to keep secret. Even in countries where prices are imposed by governments, such as communist states, 'real' prices soon emerge in the black market. Events with widespread economic impact, such as crop failures, are rapidly communicated to an entire population in the form of price changes, and can also lead quickly to political change.
The effect of money and law was to separate trading from friendship. The rule of law means that one no longer needs to build up a relationship of trust in order to trade. The priority becomes no longer to make a deal with the best person, but to obtain the best price. And the more impersonal things are, the better, in the sense that the best-price transaction is economically beneficial to everybody.
Adam Smith was the first to comment on this: It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest This division of labour It is the necessary, though very slow and gradual, consequence of a certain propensity in human nature which has in view no such extensive utility; the propensity to truck, barter, and exchange one thing for another.
The theory of markets starts with Smith, the Scottish Enlightenment philosopher who first argued that greed was good. In The Wealth of Nations , published in the year of the American revolution, Smith paints a picture of ruddy-cheeked butchers, bakers and brewers who each put their own interests first, and yet create wealth collectively. Back in , this was a radical idea.
Before the industrial revolution, markets were seen as a low-grade human activity, which often fell under the Devil's influence. And where was the evidence that contracts like shares actually helped anybody? In , when Smith was only three-years old, this hostile view of free markets had been confirmed by the scandal of the South Sea Bubble. Founded by a Tory minister in , the South Sea Company was intended to profit from trade with the Spanish colonies, but instead, used shareholders' money to pay off the national debt.
To stoke public interest, the directors of the South Sea Company sold additional stock, which investors could use as security to borrow money to buy yet more stock, and even issued a press release to promote their efforts. This pyramid investment scheme gathered momentum, and by early it had spawned dozens of imitators.
Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It
I was prompted into buying this book after seeing a truly hopeless Channel 4 documentary about the LTCM collapse which attempted - but failed entirely - to explain what LTCM was all about: What the Brick by brick, the editor of Risk magazine, builds the origin of the option and bond models, and introduces the cast of Nobel winning and big-buck trading characters. Well-researched, and worth Nicholas Dunbar , Nick Dunbar. The Washington Post described the collapse of the massive hedge fund Long-Term Capital Management as "one of the biggest financial missteps ever to hit Wall Street.
Nicholas Dunbar. Whatever we select for our library has to excel in one or the other of these two core criteria:. We rate each piece of content on a scale of 1—10 with regard to these two core criteria. Our rating helps you sort the titles on your reading list from adequate 5 to brilliant
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