Black-Scholes: The Math Formula Linked to the Financial Crash. –BBC
This piece really has no new information in it, so if you’re looking for that, you can stop reading here. Instead, it’s for Anglophiles. Â Observers of British culture. Â
The BBC recently posted rather prominently a piece pondering the tragedy of the human condition wistfully, as it so often does. Â Well, that’s not quite what the article was about. Â Actually, it’s rather hard to tell what the article is about!
BBC begins by saying that those guys on Wall Street use algorithms and financial modelsâ€”and one model in particular, it tells us in the first paragraphâ€””helped to blow up the world” . . . but before telling usÂ whoÂ says that about Black-Scholes, the BBC first meanders back to ancient Japan where we learn about theÂ Dojima Rice Exchanges in 17th Century, and how markets work. Â Then we get to hear a good deal of Myron Scholes’ biography.Â
Finally, in the piece’s fourteenth paragraph, we finally learn that thereÂ isÂ apparently one “Ian Stewart, whose book argues that Black-Scholes was a dangerous invention.”
TheÂ BBC never tells us what that book is, so you’ll have to look it up. Â (We did, and think it’sÂ Seventeen Equations that Changed the World.)
Finally, the article concludes: Â But can we really blame Black-Scholes for the financial crash? Â Well, no. Â Not really. Â But you know: Â It’s a dangerous tool. Â Like, say, fire. Â Or for that matter, the automobile, airplane, and pretty much everything else in the modern world. Â
(It’s kind of like those news show teasers: Â “Coming up! Â At 10 p.m. Â Do pineapples cause cancer? Â Tune in to find out!” Â And you see that teaser for an hour or two before the show, and then at the beginning of the show, and even halfway through it, and then you get to the end of the show and find out that actually . . . No. Â Pineapples don’t cause cancer. Â Or at least there’s currently no reason to believe they do. Â But somebody was concerned!)
Ian Stewart claims that the Black-Scholes equation changed the world. Does he really believe that mathematics caused the financial crisis?
“It was abuse of their equation that caused trouble, and I don’t think you can blame the inventors of an equation if somebody else comes along and uses it badly,” he says.
“And it wasn’t just that equation. It was a whole generation of other mathematical models and all sorts of other techniques that followed on its heels. But it was one of the major discoveries that opened the door to all this.”
Black-Scholes changed the culture of Wall Street, from a place where people traded based on common sense, experience and intuition, to a place where the computer said yes or no.
But is it really fair to blame Black-Scholes for what followed it? “The Black-Scholes technology has very specific rules and requirements,” says Scholes. “That technology attracted or caused investment banks to hire people who had quantitative or mathematical skills. I accept that. They then developed products or technologies of their own.”
Not all of those subsequent technologies, says Scholes, were good enough. “[Some] had assumptions that were wrong, or they used data incorrectly to calibrate their models, or people who used [the] models didn’t know how to use them.”
Scholes argues there is no going back. “The fundamental issue is that quantitative technologies in finance will survive, and will grow, and will continue to evolve over time,” he says.
But for Ian Stewart, the story of Black-Scholes – and of Long-Term Capital Management – is a kind of morality tale. “It’s very tempting to see the financial crisis and various things which led up to it as sort of the classic Greek tragedy of hubris begets nemesis,” he says.
“You try to fly, you fly too close to the sun, the wax holding your wings on melts and you fall down to the ground. My personal view is that it’s not just tempting to do that but there is actually a certain amount of truth in that way of thinking. I think the bankers’ hubris did indeed beget nemesis. But the big problem is that it wasn’t the bankers on whom the nemesis descended – it was the rest of us.”
There will always be an England. Â One that longs for the simpler times of a country life. Â In fact, the author of this BBC piece seems rather thrown out of sorts by the whole modern world, and we wondered it perhaps the folks at the BBC might benefit from reading Kevin Kelly’s Interview with Kirkpatrick SaleÂ from some years back. Â Two decades ago. Â The good old days.Â
If you look at the Black-Scholes Formula Too Closely, for Too Long, It’s Said Your Head Might Explode