Little piece of vol quant history for you, which is essentially correct. Lots of lessons here - some were learned 20 years ago, others not.

risklatte.xyz/Articles/Histo…

TL;DR - Goldman isn’t big in exotics, here’s why.
My memory of the dates is that this happened earlier and was done by 2003 but the story fits, I priced and risk managed these and we couldn’t get near the GS price. I think they lost 100M all told, back when that was a lot
There was a nice 6 month period when the street figured out what GS had done and nobody told them. (They were loved, even back then)
One lesson learned was that local vol has strong limitations on it for forward starts (cliquets). Lorenzo Bergomi’s monograph is the best source for why (and a great, great book overall). This shitshow explains why he spends 100 pages shooting down local vol
GS never found another way they trusted to price exotics, and they are still right.
The Europeans thought this was hilarious, didn’t learn the same lesson, and spent 2002-2008 building stochastic vol models. Hence Bergomis book.
Unfortunately the tradeoff with the new models was as follows: you’re gamma hedged so you have neutralised your exposure to realised moves. This is good as they are hard to predict.
In their place you have exposure to a bunch of Greek letters that you have some intuition on but not much. You hope they don’t move much. You try to find ways to offset that risk even though you know it’s likely model dependent
This all makes sense in stable markets, your volzomma parameter won’t move and you can keep taking margin. Unfortunately the global equity market has become more leveraged and prone to explode every 3 years. It’s not gone well.
This episode is also why JP doesn’t have big exposure to retail exotics. They never got comfortable with the game - if GS could get it wrong anyone could. They kept it simple.
One other lesson was that the customer will buy whatever you sell them. They can’t tell whether you can hedge or not. They’re morons and that’s actually dangerous for the seller - you’re on your own.
This is topical as after losing again in 2020 despite huge investment in ‘risk management’ a lot of European banks are finally coming round to the US view - some products shouldn’t exist.
Equivalently that trade off between realised vol exposure and volzomma may not be a good one in the long run.
Maybe they’ll actually go do some time series analysis and look at what they’re trading. That would seems to be the way forward.

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More from @Mephisto731

1 Feb
OK so: summary. Is it me or is this nonsense over now? Feels like it to me.

It's not a pandemic or LTCM, or Europe 2011. It's more like XIV day, or a quant quake, or the flash crash, or flooded Japanese reactors, or all the other idiosyncratic fun we've had in times past.
1/n
RH has the extra cash it needed, this seems to keep them going. I do believe their brand is OK and they will survive, as I do believe they are good at finding another sucker. And yes Citadel still loves them.
2/n
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3/n
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1. When we are all awash in information, as all market players now are, the defining feature of each of us is what we choose to ignore - or better, what we choose to forget and how fast.
2. ( Apologies for the Naval tweet )
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Rant mode on. I don’t care about your big data. Increasingly I care about small data. If you can talk sense having very little data then you have a chance when more data arrive. The converse is not true
We saw screens go wide or empty in March. How did your cutesy machine learning algo do then?
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Threads to take to your mind off things, something more interesting I hope. Part 2.
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I've been looking at variance swaps (again), SPX skew termstructures (again), the CBOE $SKEW index and a couple of beautiful papers by Neuberger that made me smile - there's a nice trick.

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Here's a puzzle: var swap replication uses option prices at maturity (and 30 days for $VIX), nothing in between now and then.
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There's a flip in the dimension from a sum over strikes to a sum over days. Its objectively weird but rarely discussed as such.

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