The Little Equation at the Heart of the Economic Collapse

Illustration for article titled The Little Equation at the Heart of the Economic Collapse

When the global financial markets began to collapse in 2007, everybody turned on the banks and bankers — and they haven't stopped since. But one of the culprits was a humble piece of mathematics: the Black-Scholes equation.


Most people know that the financial crisis was a result of things called derivatives: investments made on investments. These bets on bets lack the tangible qualities of conventional trades based on money or goods, but they are extremely lucrative, and over the last 20 years became a staple in the world of finance. Writing for the Guardian, Ian Stewart describes how the concept of trading derivatives was made possible by the Black-Scholes equation.

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.


It is, of course, impossible to blame an equation for the state of our economy: that has to lie at the feet of those that were using the mathematics. But it is fair to say that without the Black-Scholes equation, the last five years would have been entirely different. Quite how different, we'll never know. The full piece at the Guardian makes for a fascinating read, do check it out: [The Guardian]

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the worst part is the large list of assumptions that underlie the equation, which rarely if ever accompany the formula, and therefore get forgotten, but they're the most critical part; the operating conditions, if you will.

as long as those assumptions hold true, Black-Scholes is more or less right, but the risk identification and adjustments were massively undermined by exceptionally loose credit, which was hidden by artificially compartmentalizing relative risk as though it were absolute.

had we responsible risk ratings this would have been mitigated somewhat, for those rating agencies essentially guard the assumptions.

check out the impact of false premise: []