Ian Stewart gives us a taste of his new book Seventeen Equations That Changed the World in a Guardian article about the Black-Scholes equation. This, he says:
provided a rational way to price a financial contract when it still had time to run… 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.
So what went wrong? Stewart explains that “the equation itself wasn’t the real problem”, going into some detail about how the equation was derived, how it works and what assumptions are included. He concludes:
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.
Ultimately, Stewart argues, “the financial sector performs no better than random guesswork”, with the system “too complex to be run on error-strewn hunches and gut feelings, but current mathematical models don’t represent reality adequately”, a situation that requires “requires more mathematics, not less”.
Guardian: The mathematical equation that caused the banks to crash.
