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Paradox plays a part in a modern fable of economics

By John Kay

Published: July 30 2007 18:58 | Last updated: July 30 2007 18:58

What is the link between a visit to Russia by an 18th century Swiss mathematician, collateralised debt obligations, and the philosopher’s stone?

The Swiss mathematician, Daniel Bernoulli, first propounded the St Petersburg Paradox. A version for today’s markets envisages a casino with a coin-tossing game at fair odds. You hope to win at the first toss with a £100 stake. But if you lose, you will stake £200 on the next throw. If you lose again, you raise your stake to £400, and so on. You keep doubling your bet until you win. Simple mathematics shows that when you do win, you recoup all your previous losses and make £100 profit. Since you are bound to win eventually, the scheme is a sure means of winning £100.

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