There was a time when I would regularly run into a particular investment banker. After trying to sell me something he would invariably speak about various topics. On one particular occasion we were speaking about a potential event occurring and the banker asked me what my delta was on the event. I was confused and asked him what he meant. The banker responded “You know, your delta? What’s your delta? What’s the probability that you think this event will happen?”
For those of you who don’t know, delta is a Greek letter used by traders that, in simple terms, is used to denote the change of price in one security due to a change in price of another security. For example, if a $1 change in the price of a share causes a $0.2 change in the price of an option then the delta is 0.2.
Probability is simply how likely an event is to occur. It is important to understand that a probability must be greater or equal to zero and less than or equal to one. The delta can be any number including greater than one as well as negative numbers. Saying to someone “What’s the delta? You know, the probability of it?” is akin to saying “What colour is it? You know, how heavy is it?” This was in 2004. I should have seen the 2008 collapse coming.
For those of you with an options background: the banker was selling delta-one, positive gamma structures and assumed that since the delta in this case was bounded by [0,1] that this must therefore be equal to a probability.
For those of you who didn’t understand the previous sentence, don’t worry neither would the banker. The difference is, you weren’t selling billions of dollars of structured products, affectionately known as toxic waste, to innocent clients.
So, am I simply making fun of an investment banker for not understanding probability? No, but I am chastising him for selling complex structures to clients without having the ability to explain the risks to said clients. Imagine a doctor not being able to explain the risks of a medication before he offers to prescribe it for you.
Probability is difficult because it is unintuitive. Evolution, sadly, did not select the intrepid mathematician caveman to propagate the species. That branch of homo sapiens was quickly killed off by scary predators. Instead, homo sapiens capable of using fast heuristics and rules of thumb are the ones who survived. You know, the jocks. The financial derivative, a far scarier predator than T-Rex, had not been invented yet and probability therefore was of little use.
Fast forward to the modern day and catching a thrown object, such as a ball, requiring massive amounts of calculations and a deep understanding of Newton’s Laws of Motion, seems effortless. Calculating the odds of rolling a dice three times and getting an even number each time, requiring a handful of calculations, seems as complex as performing black magic requiring arcane skills. I refuse to include a Harry Potter allusion. I would have considered The Lord of the Rings if not for the horror of The Hobbit.
Now that I have made up for rudely going into options theory by making nerdy fantasy fiction references, the question remains what is the point that I’m getting at? It is this: Probability is hard to learn and understand. This is not a fault of anyone trying to learn it, it is a fact of nature. The bankers running around selling complex derivatives need to have a better understanding of what they are doing. At the very least they should bring along the structurers that thought up these monstrosities.
This won’t necessarily stop Wall Street from repeatedly blowing up the global financial system (go globalisation!) but at the least it closes one door.
In conclusion, if you run into a banker who mentions delta, gamma, vol, theta or, one shudders, vega, then run, don’t walk, to the nearest exit. It is no coincidence that Greece is bearing the brunt of the global financial collapse. They are being punished for allowing their alphabet to be appropriated, and perverted, by Wall Street.