The Importance of Being Honest

This is a great article by E. Derman and Paul Wilmott on  how we should be careful with our models. Here are their suggestions at the end,

• I will remember that I didn't make the world and that it doesn't satisfy my equations.
• Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
• I will never sacrifice reality for elegance without explaining why I have done so. Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.
• I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension. 

It is so easy to get lost in the mathematics of models that we often see papers completely out of touch with reality...

Hedging World Cup Risk

Today I was walking around Barcelona and saw this interesting time-deposit offer from Banesto (a local bank). They promise you 3%/year, but IF Spain wins the World Cup, the investor gets 4%.

Around the World Cup we see all kinds of offers like this (in Spain, the UK, and Brazil at least): buy a flat-screen TV and if Brazil wins you get another one, etc.

An interesting question is how much money does the bank expects to spend with this offer? How should  this be hedged?  Of course, based on historical probabilities they won't lose a dime, but with Spain being one the favourites, what to do to at least find an estimate? 

Supose that the bank's reinvestment rate is 4%. If Spain does not win the World Cup, they make a 1% profit. If Spain does win, they make zero. The expected return is the 1%*(Prob Win), which looks good on their side given previous history.

I wonder if they could hedge this against a portfolio of online bets held by betting houses. 

Any ideas? This might turn into a nice exam question or topic for the derivatives course.