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INTRODUCTION:

It was a brilliant discovery that revolutionized modern finance. An elegant

mathematical formula that helped creates a multi trillion dollars industry. In
moment of tremendous clarity they realized that two risky positions taken it can
eliminate risk. This bold idea shaped one of the most ambitious investment
strategies in history attracting the elite from Wall Street which confronted them
with the biggest risk of all. Market began to act ways no one has seen before. It
began to lose $100 million or more day after day came a day when they lost ½ a
billion dollars in single day. These money machines driven by mathematical
models had earned fantastic suns now as they spiraled out of control. Investors
began to freeze to terror due the loss in the stock market. The crises threatened
to bring markets around the world to the break of a collapse in quest to avoid a
global economic downfall.

CAPITALIZME:

Since the dawn of capitalism there has been one golden rule: ͞if you want to
make money you have to take risk͟ then came one of the most individual
endeavors of the century, the attempt to find a mathematical way to conquer risk
to turn finance into a science. If it worked it was thought that it would open new
rounds for world͛s financial exchanges and forever change the way trader͛s trade.

BEN SCHWARTZ (Chicago Mercantile Exchange):

He said ͞I have seen many people come and go. People come with good fresh
attitudes to the market but can͛t survive or handle the competition. Market is not
for the weak If u cannot handle it you cannot be there and it͛s otherwise that
people might take your money and don͛t even feel bad.

He said and elaborated that the exchange on which he works trades many strange
and complex things like pork Billy futures, Interest rates swaps, Currency
deviances. These prices are constantly fluctuating as the market sentence shifts.
The job of the trader is to try to guess what these prices be next year, week or in
10 sec time.͟

He further said that a successful mathematical model that could improve the
trade off between risk and reward would have to beet the instants of an ordinary
trader on the floor plus it will have to compete with the accumulated wisdom of
an acknowledged expert.

LEO MILAVIDA (Chief architect of financial futures):

He has been in successful trading business over 30 years. He described that:͟

what I do is that I pick up the phone to my clerk who is at the bid and she flashes
in the order through a hand signal to the broker in the bid who handles my
account & he then executes the order that I gave that gives her the conformation.
The day is before me and I have to figure out which direction many one market of
the dozen is gone go. Additionally you have to figure out from newspapers being
a psychiatrist the public attitude, which way they are going today, what they will
do, is this information gone make them bullish or fearer. If I can figure that out I
can beat the market.

ANALYSIS

Traders like Milavida convinced that success in markets involved

Y Human judgment
Y Business savvy
Y Intuition

All of these were those that could never be reduced to a series of equation. But
an important group of financial economist who studied markets mathematically
believed that such success largely is a matter of luck.

STOCK MARKETCRASH OF 1929 & ECONOMIST FINDINGS OF TRIGGERS:

After stock market crash of 1929 economists started to find out whether triggers
could really predict How prices moved by looking it into past patterns. They
decided to run a series of experiments. In one of them they simply only picked
stocks at random. At the end of the year this random choice out performed the
predictions of top traders. This was a revelation.

Prices moved totally random and although patterns came and went they were
there by chance alone and had no predictive value. The economists arrived at a
devastative conclusion. It seemed that the top traders of the market worked on
shear luck rather than skills of the market.

MERTON MILLER (Economist university of Chicago)

He was of the view that ͞ if this ten thousand people looking at the stocks and try
to pick winners, one in 10,000 is going to escort by chance alone and it͛s a chance
operation and people think they are doing something purposeful but they are
not.͟

According to economists when traders like milavid dig up information & quickly
acted upon, the results in the market price reflected that research. Ironically the
very predicting prices made them less predictable but economist new that
mathematics has been successfully used to study random phenomena before
from population growth to weather forecasting. Using esoteric theories of
probability they could model the fluctuations in their quest to model risk.

PAUL SAMULESON (Economist MIT)

He opinioned that ͞the hope that mathematical theory of probability and

statistics could be a skeleton key to help you understand the nature of chance
perhaps to predict it better and to control it that was born at that time and the
rest as they say is history͟.

LUIE BACHILIE & THEORY OF SPECULATION (1930)

Unknown to the economists of 1930s, a French graduate student took the turn of
the century. Luie bachilie was one who had already exploited the structure of
randomness in his doctrine thesis titled as the theory of speculation. He
compared the behavior of buyers and sellers to the random movements of
particles suspended in the fluid anticipating key insights latter developed by
Einstein and mathematics of probability.

Y FIRST Ever Stock Market Fluctuations Mathematical Model: using series of

equation Bachilie created the first complete mathematical model of stock
market fluctuations as he too believed that stock prices moved at random and
were impossible to predict.
Y Options: He then found a way to control Risk through an obscure financial
contract called an option. He realized that options could protect investors
from market fluctuations and made the first attempt to figure out how to
price them. But his superiors were unimpressed and his academic career
faulted.

ECONOMISTS, OPTIONS& DERIVATION OF PERFECT MATHEMATICAL FORMULA

The next step needed for bachilies work was to get a perfect mathematical
formula to evaluate and price options. Economists eagerly returned to the
markets to investigate the strange contract which had so intrigued Bachilie. They
discovered that options were form of insurances that allowed investors to buy
and sell stocks for specific amounts, the stock prices by specific date e.g. if some
one bought a stock today, the price may drop in future and money cam be lost
but if buy an option one may have the right to sell the stock at some agreed price
in future. If the stock drops it͛s insured if it raises its profit.

Options could be an effective way to control risk but how much should an
investor pay for such absolute peace of mind. The value seemed to depend on
each individual͛s level of confidence in the market. No one could agree on a
standardized way to price options. It was a problem that economists were
determined to solve.

THE 1960s ERA

Throughout 1960s economists developed mathematical models to describe

emotional state of investors to know the investment decisions they take in
purchasing the amount of options and stocks. They developed and devised
symbols for factors like

Y Satisfaction level of investors

Y Aggressiveness
Y Symbols for guesses of triggers

But would it worked?: the mathematical model developed during 50s and 60s
dependent on inputs that were completely unobservable like Expectations of the
investors and no number could be given to them.

STAN JONES (FIMAT broker)

He said that ͞these models talked about people utility structures, risk aversion
which made all the models psychotherapy than real science.

By the end of 60s economists came now nearer to pricing options but this was
about to change.

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