Tuesday, April 26, 2011
Wednesday, April 20, 2011
According to Fischer, the crash was well within his broadened conception of equilibrium with costly information and noise trades. A couple of years later, Fischer (“the theorist”) would eventually team up with Bob Litterman (“the econometrician”) working out on the Black-Litterman asset allocation model. The idea was to blend the passive market portfolio with the active view portfolio based on ex ante expected deviation of performance from equilibrium, using the international CAPM to estimate the expected returns. Besides, the solution to blend the theoretical equilibrium allocations with the client’s view was to treat both as independent measures of an unknown parameter; each one measured subject to error, and then calculate the best combined estimate. The Goldman Sachs asset management adopted this model which was improved later on extending it to include equities and finding other uses such as running it backwards or either using it as a tool for risk control.
In 1994, Fischer had some health issues ,by the way, shifting his focus to sum up his life’s work.
Monday, April 18, 2011
In addition to his professional success, Black now had himself a lady. He married Cathy Tawes, who had recently divorced from another partner at Goldman. Unfortunately, the book (in this section at least) does not go into details about the awkward scene at the meeting where the guy that Tawes just left and Fischer Black got into a fight over Cathy. Certainly a missed opportunity there.
Missed opportunities for literary gold notwithstanding, Fischer and Cathy were happy together. Unlike with his previous wife Mimi, their personalities fit just right so that he could continue to be a workaholic, and she wouldn't mind. She already had kids of her own, so all Fischer had to do was fit into the family.
Goldman Sachs needed a better model of the embedded bond option, and valuing fixed income derivative products. This need was brought to Fischer’s attention, and he came up with the Black-Derman-Toy (BDT) computer model, which was later published in 1990. The BDT model worked much better than Black Scholes when it came to valuing bond options. Fischer was able to develop BDT quickly because he had been thinking about it since he attended Modigliani’s talk’s years ago. Modigliani expressed that the most important thing missing from an ideal pricing model was the implementation of risk and uncertainty.
Richard Roll was hired by Goldman Sachs to build a Mortgage Security Research capability within the Fixed Income Division; he tried to utilize CAPM to build the model. Years later, Roll and Fischer met and were able to analyze Roll’s empirical model and Fischer’s more theoretical BDT model. Fischer agreed that BDT had a few problems from the trader’s perspective, and portrayed an unrealistically high equilibrium. However, BDT worked well for firms to price custom options, and to calculate the correct hedge.
In a paper, Fischer explained the constant upward slope of the term structure can be clarified by viewing interest rates as options.
This section shows that Fischer was unconcerned about how much money or value was lost and was more concerned about explaining why it happened.
Fischer and Rob Jones worked at Goldman Sachs to develop a portfolio insurance, something that a firm by the name Leland, O'Brien, Rubinstein had developed to ensure that portfolios would not fall below a certain level. Fischer developed the constant proportion portfolio insurance which in his words was easier and better to use then the LOR.
Although Fischers constant proportion portfolio insurance was not implemented in time before the crash he was able to understand what factors influenced the crash. He concluded that the crash was a result of noise.
Sunday, April 17, 2011
Even though the CAPM was always on Fischer’s mind, his expertise in option pricing provided more opportunities. However, the Markets started using Fischer Black’s CAPM model more so than he anticipated. When derivatives came to market, Black was not too impressed, initially. According to Black, derivatives were not necessary. Not until after he realized derivatives could be used to hedge real risk, he embraced the new idea and saw how it could fit in with his ideal CAPM world.