Monday, March 3, 2008

Black Scholes - the root of all evil?

Last week, one of my MBA students handed me a copy of "Conde Naste Portfolio" which featured an article about the Black Scholes option pricing model. The article is also online and FinanceProfessor has a link to it here.

The article is pretty poor (although the magazine is very glossy!) First of all, it basically rehashes all the material in the PBS Nova TV special from a few years ago which looked at Black Scholes and the collapse of Long Term Capital Management. The Black Scholes Model was blamed for all the ills of the world back then. To make the topic more current, the author of the piece cites a Nicholas Taleb who has basically made a living trashing Black Scholes. People listen to this guy because back in 1987 he correctly bet that the market would crash. By his own admission, he hasn't been able to repeat that feat since - hmmmm. Anyhow, he has this to say about Black and Scholes:
"This is what I'm saying to Merton and Scholes," "You guys are just parasites. You're not bringing anything useful to the market. You are lecturing birds on how to fly. You're watching them fly. And then you're taking credit for it."

He also thinks that they should have the Nobel revoked.

I'm sorry Mr Taleb, but you are so far off base here, your comments barely dignify a response. The Black Scholes model is a model, and just that. It assumes that the risk input that you use is a reasonable estimation of the future risk of the security. If the security does something drastically different to what it has done in the past, then the model will misprice it. Garbage in, garbage out. If you use the model and don't recognize this, then you'll likely get burned.

Mr Taleb, don't go shooting the messengers (or in this case trashing the authors) of the model in such an unprofessional manner.