The Midas Formula

For this week’s blog, I watched a documentary called ‘The Midas Formula.’ No, this isn’t a documentary about the story of King Midas and his ability to turn everything he touches to gold. The Midas Formula is a finance documentary revolving around the stock market. After all, this is a finance blog and so it should come as no surprise that the documentary will have a financial theme. In this blog, I will give some background about what The Midas Formula is about and explain what I learned and understood from watching this documentary. Then, I will look at different theories from my module International Finance and Responsible Financial Management which were brought up or are applicable in the context of the documentary.

So, you are all probably wondering what The Midas Formula is and how it is related to finance. The Midas Formula is more commonly known as the Black Scholes Formula (The Midas Formula, 1999). The Black Scholes formula was designed to eliminate risk from trading on the stock market. The initial formula Black and Scholes derived included Stock Price, Volatility, Duration of the Options Contract, Interest Rate and Risk (The Midas Formula, 1999). All these variables were quantifiable, except one. Risk. Using a similar method that gamblers used, Black and Scholes were able to create a theoretical portfolio in which they hedged their bets by betting opposite using option contracts. Option contracts would allow a trader to agree to buy a stock only if the stock reaches a certain price (The Midas Formula, 1999). This was basically insurance on trading. Through hedging their bets, Black and Scholes were able to cancel out any movement in their portfolio, effectively eliminating risk. Subsequently, risk was removed from their equation. They called this method, dynamically hedging (The Midas Formula, 1999). Finally, the Black Scholes formula was complete and applicable in the real world. Traders everywhere used the formula and Scholes decided to create a large hedge fund company called Long Term Capital Management (LTCM) (The Midas Formula, 1999). LTCM promised to use mathematical modelling to make investors more money than ever seen before. Their customers were some of the most prestigious investors and within months they had raised $3 billion (The Midas Formula, 1999). LTCM started brilliantly giving their customers returns of 20%, 43% and 41% in the first three years (The Midas Formula, 1999). However, an unexpected event in Asia caused stock prices to change dramatically. LTCM took on $100 billion in debt in order to meet the inflated option prices and continue dynamically hedging (The Midas Formula, 1999). They calculated they could continue to dynamically hedge if one more improbable thing didn’t happen. Russia then refused to pay their international debts causing the stock prices to unexpectedly fluctuate again. LTCM were losing $100 million a day and 4 days later, they lost $500 million in one day (The Midas Formula, 1999).

Early in the documentary, a professor from Boston University claims that winning on the stock market is pure luck (The Midas Formula, 1999). The documentary also mentioned an experiment academics carried out in the 1930s where they threw darts at the wall street journal whilst blindfolded and bought stock in whatever they hit (The Midas Formula, 1999). After 1 year, they had outperformed the predictions of top traders showing the unpredictability of the stock market (The Midas Formula, 1999). This is an example of Random Walk theory in which it is believed that the stock market follows a random walk and so it is impossible to know which way the share price is going to go (Kendall & Hill, 1953). The theory states that prices only move due to new information and so it is impossible to predict how the stock market will change as it is impossible to know what will happen (Kendall & Hill, 1953).

Modern portfolio theory shares similarities with what Black and Scholes were trying to do when they were hedging their bets in order to cancel out movement in their theoretical portfolio (Elton & Gruber, 1997). Modern portfolio theory suggests that in order to diversify a portfolio, investors should avoid investing in stocks which have a strong positive correlation to another stock in their portfolio (Elton & Gruber, 1997). Instead, investors should look to invest in stocks which have a strong negative correlation with other stocks in their portfolio as when one stock goes down the other will go up and so there is less risk (Elton & Gruber, 1997). This is like how Black and Scholes eliminated risk from their formula by dynamically hedging (The Midas Formula, 1999).

Overall, I found the documentary very informative as I have never heard of the Black Scholes formula or LTCM before watching. It is interesting to note that at the end of the documentary, it is stated that investors still use this formula today (The Midas Formula, 1999). However, I would guess with a little more scepticism considering what happened to LTCM (The Midas Formula, 1999). I wonder whether someone else will come along and try to use mathematical formulas to try and eliminate risk from the stock market and make themselves and others rich.

Reference List

BBC. (1999). The Midas Formula [TV programme]. BBC2.

Elton, E. J., & Gruber, M. J. (1997). Modern portfolio theory, 1950 to date. Journal of Banking & Finance, 21(11-12), 1743-1759.

Kendall, M., & Hill, A. (1953). The Analysis of Economic Time-Series-Part I: Prices. Journal of the Royal Statistical Society. Series A (General), 116(1), 11-34. doi:10.2307/2980947