Friday, October 24, 2008

Greenspan's Turkey

Apparently Greenspan was also a Jive Turkey =)
I first came across the Turkey analogy when I read Taleb's Black Swan book. The analogy was funny yet salient so I thought I'd share. After seeing Greenspan's quote I just had to bust this infographic out.

Greenspan's Jive Turkey Quotes

"once-in-a-century credit tsunami""That is precisely the reason I was shocked because I'd been going for 40 years or more with very considerable evidence that it was working exceptionally well."

In the future, I hope we avoid being jive turkeys....

An interesting point... I was testing Black Scholes Merton equation's sensitivity to input volatility error for 'way out of the money' calls and puts and found an interesting example.

(if you don't care about derivative pricing then skip this section)

Take a call option with 1 year left before expiration, a strike price of $100, the current value of the underlying asset is $50... the volatility is 20%, and the risk free rate is 4.5%..... The call option price of this scenario is about $0.002.... Say the 'true' volatility was actually 26.6%, in this case the appropriate price for the call option is $0.044.... notice the raw sensitivity to the input, a 33% change in the volatility input results in a 22X change in the price... thus, you better be on point with your volatility input. This of course only matters if you believe the assumption that reality actually follows the Gaussian distribution into the tails..... (If you don't then this is an exercise in futility, if you agree with Mr. Taleb then this top-down approach is silly, this example is just to illustrate that even if the model constraints are true, you are still subject to massive swings in your solution if your inputs are even marginally off). Otherwise you might get a nasty surprise when this option exercised and you have to honor your end of the obligation... OOPS you charged WAY too little for this option... This is a good example of when not to be a turkey... This is an example I came up with after reading the Black Swan. The fragility of the Black Scholes Merton model is known to practioners and academics alike (My 'very smart professor' Zhao actually made us read a paper on the fragility of the model during my derivatives class after showing us the method.)
Anyhow, don't feel bad if your a turkey sometimes... just hope your not being a turkey when your house of cards is stacked to the ceiling. =)

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