1,221 karma · joined March 1, 2013
First of all, the vast majority of LTCM's trades had nothing at all to do with the Black-Scholes-Merton formula (BSM). They were just highly levered mean reversion trades. The fall of LTCM had nothing to do with the BSM formula, it had everything to do with leverage.
Secondly, vanilla BSM with constant volatility isn't really used to do anything important anymore. It was going away much earlier than 1997 anyway; the Heston model came around in 1993, and Derman was using a primitive version of local vol around the same time. And of course people knew that financial asset returns were not normally distributed with constant vol (Mandelbrot wrote a paper describing that in 1963!).
I won't even get into why his (and Salmon's) description of how the Li formula was used is completely wrong.
"Nowhere is that more evident than in the U.S., where lending to the government should be far safer than speculating on the direction of interest rates with Wall Street banks."
You aren't "speculating on the direction of interest rates with Wall Street banks", you're buying a synthetic rates position that is centrally cleared with daily variation margin. That's not quite US Treasury safe, but it's pretty damn safe.
Compare this to before, when swaps were often un-collateralized, so you might have a huge paper profit on a trade that you'll never actually realize because the counterparty lacks the cash to settle up.
So before, you could lose the total amount of your trade, but now you can only lose a day's worth of gain or loss.
This is a big improvement, and the risk to the taxpayer is pretty de minimus. Of course the central clearinghouse could default, but that's very unlikely for a variety of reasons (mostly that the central clearinghouse's whole reason for existence is not to default).