Black-Scholes: The maths formula linked to the financial crash
Published: 28th Apr 2012 00:06:02
It's not every day that someone writes down an equation that ends up changing the world. But it does happen sometimes, and the world doesn't always change for the better. It has been argued that one formula known as Black-Scholes, along with its descendants, helped to blow up the financial world.
Black-Scholes was first written down in the early 1970s but its story starts earlier than that, in the Dojima Rice Exchange in 17th Century Japan where futures contracts were written for rice traders. A simple futures contract says that I will agree to buy rice from you in one year's time, at a price that we agree right now.
By the 20th Century the Chicago Board of Trade was providing a marketplace for traders to deal not only in futures but in options contracts. An example of an option is a contract where we agree that I can buy rice from you at any time over the next year, at a price that we agree right now - but I don't have to if I don't want to.
You can imagine why this kind of contract might be useful. If I am running a big chain of hamburger restaurants, but I don't know how much beef I'll need to buy next year, and I am nervous that the price of beef might rise, well - all I need is to buy some options on beef.
But then that leads to a very ticklish problem. How much should I be paying for those beef options? What are they worth? And that's where this world-changing equation, the Black-Scholes formula, can help.
"The problem it's trying to solve is to define the value of the right, but not the obligation, to buy a particular asset at a specified price, within or at the end of a specified time period," says Professor Myron Scholes, professor of finance at the Stanford University Graduate School of Business and - of course - co-inventor of the Black-Scholes formula.
The young Scholes was fascinated by finance. As a teenager, he persuaded his mother to set up an account so that he could trade on the stock market. One of the amazing things about Scholes is that throughout his time as an undergraduate and then a doctoral student, he was half-blind. And so, he says, he got very good at listening and at thinking.
When he was 26, an operation largely restored his sight. The next year, he became an assistant professor at MIT, and it was there that he stumbled upon the option-pricing puzzle.
One part of the puzzle was this question of risk: the value of an option to buy beef at a price of - say - $2 (£1.23) a kilogram presumably depends on what the price of beef is, and how the price of beef is moving around.
But the connection between the price of beef and the value of the beef option doesn't vary in a straightforward way - it depends how likely the option is to actually be used. That in turn depends on the option price and the beef price. All the variables seem to be tangled up in an impenetrable way.
Scholes worked on the problem with his colleague, Fischer Black, and figured out that if I own just the right portfolio of beef, plus options to buy and sell beef, I have a delicious and totally risk-free portfolio. Since I already know the price of beef and the price of risk-free assets, by looking at the difference between them I can work out the price of these beef options. That's the basic idea. The details are hugely complicated.
"It might have taken us a year, a year and a half to be able to solve and get the simple Black-Scholes formula," says Scholes. "But we had the actual underlying dynamics way before."
The Black-Scholes method turned out to be a way not only to calculate value of options but all kinds of other financial assets. "We were like kids in a candy story in the sense that we described options everywhere, options were embedded in everything that we did in life," says Scholes.
By 2007 the trade in derivatives worldwide was one quadrillion (thousand million million) US dollars ”
But Black and Scholes weren't the only kids in the candy store, says Ian Stewart, whose book argues that Black-Scholes was a dangerous invention.
"What the equation did was give everyone the confidence to trade options and very quickly, much more complicated financial options known as derivatives," he says.
Scholes thought his equation would be useful. He didn't expect it to transform the face of finance. But it quickly became obvious that it would.
"About the time we had published this article, that's 1973, simultaneously or approximately a month thereafter, the Chicago Board Options Exchange started to trade call options on 16 stocks," he recalls.
Scholes had just moved to the University of Chicago. He and his colleagues had already been teaching the Black-Scholes formula and methodology to students for several years.
"There were many young traders who either had taken courses at MIT or Chicago in using the option pricing technology. On the other hand, there was a group of traders who had only intuition and previous experience. And in a very short period of time, the intuitive players were essentially eliminated by the more systematic players who had this pricing technology."
Listen to More or Less on BBC Radio 4 and the World Service, or download the free podcast
That was just the beginning.
"By 2007 the trade in derivatives worldwide was one quadrillion (thousand million million) US dollars - this is 10 times the total production of goods on the planet over its entire history," says Stewart. "OK, we're talking about the totals in a two-way trade, people are buying and people are selling and you're adding it all up as if it doesn't cancel out, but it was a huge trade."
The Black-Scholes formula had passed the market test. But as banks and hedge funds relied more and more on their equations, they became more and more vulnerable to mistakes or over-simplifications in the mathematics.
"The equation is based on the idea that big movements are actually very, very rare. The problem is that real markets have these big changes much more often that this model predicts," says Stewart. "And the other problem is that everyone's following the same mathematical principles, so they're all going to get the same answer."
Now these were known problems. What was not clear was whether the problems were small enough to ignore, or well enough understood to fix. And then in the late 1990s, two remarkable things happened.
"The inventors got the Nobel Prize for Economics," says Stewart. "I would argue they thoroughly deserved to get it."
Long-Term Capital Management showed the danger of this kind of algorithmically-based trading”
Fischer Black died young, in 1995. When in 1997 Scholes won the Nobel memorial prize, he shared it not with Black but with Robert Merton, another option-pricing expert.
Scholes' work had inspired a generation of mathematical wizards on Wall Street, and by this stage both he and Merton were players in the world of finance, as partners of a hedge fund called Long-Term Capital Management.
"The whole idea of this company was that it was going to base its trading on mathematical principles such as the Black-Scholes equation. And it actually was amazingly successful to begin with," says Stewart. "It was outperforming the traditional companies quite noticeably and everything looked great."
But it didn't end well. Long-Term Capital Management ran into, among other things, the Russian financial crisis. The firm lost $4bn (£2.5bn) in the course of six weeks. It was bailed out by a consortium of banks which had been assembled by the Federal Reserve. And - at the time - it was a very big story indeed. This was all happening in August and September of 1998, less than a year after Scholes had been awarded his Nobel prize.
Stewart says the lessons from Long-Term Capital Management were obvious. "It showed the danger of this kind of algorithmically-based trading if you don't keep an eye on some of the indicators that the more conventional people would use," he says. "They [Long-Term Capital Management] were committed, pretty much, to just ploughing ahead with the system they had. And it went wrong."
Scholes says that's not what happened at all. "It had nothing to do with equations and nothing to do with models," he says. "I was not running the firm, let me be very clear about that. There was not an ability to withstand the shock that occurred in the market in the summer and fall of late 1998. So it was just a matter of risk-taking. It wasn't a matter of modelling."
This is something people were still arguing about a decade later. Was the collapse of Long-Term Capital Management an indictment of mathematical approaches to finance or, as Scholes says, was it simply a case of traders taking too much risk against the better judgement of the mathematical experts?
Ten years after the Long-Term Capital Management bail-out, Lehman Brothers collapsed. And the debate over Black-Scholes and LTCM is now a broader debate over the role of mathematical equations in finance.
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.
The fundamental issue is that quantitative technologies in finance will survive, and will grow”
"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."
Additional reporting by Richard Knight
At 02:56:02 in ScotlandTwo major curling competitions are under way in Dumfries just a couple of months after Scottish competitors scooped medals at the Winter Olympics.
At 02:54:55 in ScotlandParts of a fast reactor control room at Dounreay in Caithness look set to be dismantled and rebuilt at the Science Museum in London.
At 02:47:22 in ScotlandA new service of flights between Edinburgh and Stavanger has begun operation, it has been announced.
At 02:45:05 in ScotlandMajor restrictions on traffic and parking are to be introduced in Glasgow during the summer Commonwealth Games.
At 02:45:05 in WorldThe number of people who have contracted the Ebola virus in Guinea, according to the World Health Organization, has risen to 208 - and 136 of them have died. About half of these cases have been confirmed in a laboratory - earlier cases were not tested.
At 02:42:42 in ScotlandScottish councils have too little power and are too distant from the communities they serve, according to a report.
At 02:40:04 in WorldOne of the hallmarks of the Afghan presidential election has been the prominent role of young voters and activists.
At 02:35:58 in ScotlandSkills shortages are threatening the pace of recovery of Scotland's construction industry, according to a survey.
At 02:35:01 in BusinessShares in Qualcomm, one of the world's biggest chipmakers, fell 5% in after hours trading as it issued a weaker than expected growth outlook.
At 02:34:47 in ScotlandAn independent Scotland would have to fund pension costs of an additional £450 per working-age adult each year, the UK government has claimed.
Harvard CitationBBC News, 2012. Black-Scholes: The maths formula linked to the financial crash [Online] (Updated 28th Apr 2012)
Available at: http://www.ukwirednews.com/news/1425187/Black-Scholes-The-maths-formula-linked-to-the-financial-crash [Accessed 24th Apr 2014]
News In Other Categories
Drones are becoming more common in our skies, performing a variety of tasks, from taking photos to monitoring crops and potentially even delivering broadband.
Drinking more than three large glasses of wine can push people over a "tipping point", meaning they consume about 6,300 extra calories in the following 24 hours, a report has said.
With the doors to its brand new £1million training centre officially open, one of the UK's leading apprentice training providers, Bristol based S&B Automotive Academy, is showcasing its world-class facilities by launching a series of foreign student exchanges for the first time in its 41-year history. To get a flavour of what life is like as an apprentice in the UK, the Academy hosted 16 apprentice engineers and bus drivers from the G9 Automotive College in Hamburg, Germany, as part of a Europe-wide vocational training initiative called the ‘Leonardo Programme’ with support from the European Social Fund. In a reciprocal arrangement, S&B will be sending nine apprentices to Germany during February 2012 so that they can get an appreciation of life in the automotive industry on the Continent. A further three German exchange groups are being planned for next year. Designed to assist the development of vocational skills and training across Europe, including work placements for trainees, the Leonardo Programme has a budget of €1.75bn, which is helping to encourage UK organisations to work with their counterparts abroad. In what is expected to be another challenging year for employers in the UK automotive sector, S&B’s Chief Executive, Jon Winter, claims that the exchange initiative will bring many benefits to the Academy and its apprentices: “In a world of global automotive brands, it’s important for our learners to understand the international context of the industry they have chosen to make their career. This new exchange programme will enable apprentices and Academy staff alike to achieve a better understanding of the challenges and opportunities within the automotive arena in Europe. With the Academy’s influence also extending to the USA and Asia, there’s every possibility that this initiative could move further afield in the future.” Continued Winter: “The need for skilled technicians across the world is on the increase and we actively encourage our apprentices to look at broader horizons during their training. Many of them have already learned the phrase ‘Vorsprung durch Gelehrtheit’, quite simply, ‘Advancement through learning.” In the 2010/11 academic year, S&B doubled the number of successful Apprenticeships over the previous year with some 350 apprentices graduating from the Academy. At the same time, achievement levels reached an all-time high with an overall success rate of 85%. For those learners on the Advanced Apprenticeship three-year programme, success rates were even higher, at over 98%. PHOTO CAPTION: As part of their exchange visit, S&B Automotive Academy arranged for the German apprentices to visit Hampshire bus operator, Bluestar, at its Barton Park depot. The students are pictured with S&B’s Andy West (3rd right) and Steve Prewett, Bluestar’s Area Engineering Manager (2nd right). Ends http://www.sandbaa.com
An independent Scotland would have to fund pension costs of an additional £450 per working-age adult each year, the UK government has claimed.
US actress Jodie Foster has married her girlfriend, Alexandra Hedison, the actress' representative confirms.
Two major curling competitions are under way in Dumfries just a couple of months after Scottish competitors scooped medals at the Winter Olympics.