“Successful” models & simple backtests

Seven Years Later I was reading (for the new edition Dynamic Hedging) an article by Leland and Rubinstein on portfolio insurance when I stumbled upon the following footnote:

M. Rubinstein and H. Leland, “Replicating Options with Positions in Stocks and Cash,” Financial Analysts Journal 37, No. 4 (July-August 1981), pp. 63-72. [Added Note: This article was reprinted in the 50th Anniversary Issue of the Financial Analysts Journal (January/February 1995), having been selected as one of the 22 best articles out of the 3,200 published in the Journal during its 50 year history.]

I went to the paper and it was, of course, proposing their dangerously misleading method. But it was selected in 1995, after the crash of 1987, as one of the best articles.

Further a journalist tried to argue with the great Benoit M. about the “success” of Markowitz “successful” formula ( it is its 50th anniversary). Using success in being used –not in empirical tests –as a criterion is a fraud. Astrology has been so successful (much more than 50 years, perhaps 3300 years!).Should we use such popularity as a criterion for election. “Successful”.

Now How Do We BackTest?

Simply you take the model by professor Rubinstein and the other idiot and run them through history. Further assume the nontrivial fact that people will not produce bids to be good citizens, but will back-off when you supply them with SP500 futures. (“Sunshine trading” has never worked, it is some normative economist’s contraptionl; if you don’t know what it means, no problem, it is something neclassical economists came up with to save their theories and you do not need to lknow anything about it).

Even without feedback effects, will the revision policy reduce risk? Of course not: you don’t have a clue about the value of that option that you think that you have and did not buy because of fat tails. By fat tails I mean real fat tails, scalable fat tails. See the graph in an earlier post about the payoff of option contracts and how “smooth” it gets.

In other words, a soft option (a dynamic strategy) will NEVER replace a hard option (a real contract) in the real world because the production costs are severely stochastic.

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