Tuesday, May 1, 2012

Black Scholes caused the crash?

In an interview on Radio 4 (the UK's equivalent of public radio), Ian Stewart, a Maths prof from Warwick Uni in the UK argues that the Black Scholes equation was a "dangerous invention".   This argument has been trotted out numerous times, and frankly it is pretty silly.  It's like saying that the Wright Brothers are responsible for airliner crashes.

The article talks about LTCM (Long Term Capital Management) and how the failure of that hedge fund was in part due to its usage of Black Scholes.  I disagree.  The failure of LTCM was due to excessive leverage.  The recent market crash also had little to do with Black Scholes, but was again due to excessive leverage by banks and people as well as a complete failure of risk management.

I've posted on this before - here and here.   I am sure this isn't the last we'll here of this.