The Black-Scholes equation was the mathematical justification for the trading that plunged the world’s banks into catastrophe.
It was the holy grail of investors. The Black-Scholes equation, brainchild of economists Fischer Black and Myron Scholes, provided a rational way to price a financial contract when it still had time to run. It was like buying or selling a bet on a horse, halfway through the race. It opened up a new world of ever more complex investments, blossoming into a gigantic global industry. But when the sub-prime mortgage market turned sour, the darling of the financial markets became the Black Hole equation, sucking money out of the universe in an unending stream.
Anyone who has followed the crisis will understand that the real economy of businesses and commodities is being upstaged by complicated financial instruments known as derivatives. These are not money or goods. They are investments in investments, bets about bets. Derivatives created a booming global economy, but they also led to turbulent markets, the credit crunch, the near collapse of the banking system and the economic slump. And it was the Black-Scholes equation that opened up the world of derivatives.
The equation itself wasn’t the real problem. It was useful, it was precise, and its limitations were clearly stated. It provided an industry-standard method to assess the likely value of a financial derivative. So derivatives could be traded before they matured. The formula was fine if you used it sensibly and abandoned it when market conditions weren’t appropriate. The trouble was its potential for abuse. It allowed derivatives to become commodities that could be traded in their own right. The financial sector called it the Midas Formula and saw it as a recipe for making everything turn to gold. But the markets forgot how the story of King Midas ended.
Black-Scholes underpinned massive economic growth. By 2007, the international financial system was trading derivatives valued at one quadrillion dollars per year. This is 10 times the total worth, adjusted for inflation, of all products made by the world’s manufacturing industries over the last century. The downside was the invention of ever-more complex financial instruments whose value and risk were increasingly opaque. So companies hired mathematically talented analysts to develop similar formulas, telling them how much those new instruments were worth and how risky they were. Then, disastrously, they forgot to ask how reliable the answers would be if market conditions changed.
Read the rest here.
Black-Scholes blew up LTCM in a dress rehearsal for the 2008 meltdown. Yet people still use it? Baffling.
How many times has Merriweather blown up using it?
Meriweather is like the retread NBA coach that despite a career losing record keeps landing new gigs.
The rest of the article includes the most important paragraph:
Was an equation to blame for the financial crash, then? Yes and no. Black-Scholes may have contributed to the crash, but only because it was abused. In any case, the equation was just one ingredient in a rich stew of financial irresponsibility, political ineptitude, perverse incentives and lax regulation.
this is the model that blew up the banking industry of 2008:
http://www.amazon.com/dp/1932595791/?tag=googhydr-20&hvadid=6094313367&ref=pd_sl_4h5bo4xmeg_b
LOL @ financial retards attempting to write articles about math. Black Scholes? The options pricing model?
Holy crap, that schit was old hat when I was still in business school and being taught it by Ken French, one of Fischer Black’s boys from The Chicago School.
And Merriweather may still be a dope, but it certainly wasn’t the Black Scholes model that cratered LTCM. And it wasn’t the Pythagorean Theorum, either.
______