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Magazine

BlackScholes:Themathsformulalinkedtothefinancialcrash
ByTimHarford
BBCRadio4,MoreorLess
28April2012 Magazine

It'snoteverydaythatsomeonewritesdownanequationthatendsupchangingthe
world.Butitdoeshappensometimes,andtheworlddoesn'talwayschangeforthe
better.IthasbeenarguedthatoneformulaknownasBlackScholes,alongwithits
descendants,helpedtoblowupthefinancialworld.
BlackScholeswasfirstwrittendownintheearly1970sbutitsstorystartsearlierthanthat,inthe
DojimaRiceExchangein17thCenturyJapanwherefuturescontractswerewrittenforrice
traders.AsimplefuturescontractsaysthatIwillagreetobuyricefromyouinoneyear'stime,at
apricethatweagreerightnow.
Bythe20thCenturytheChicagoBoardofTradewasprovidingamarketplacefortraderstodeal
notonlyinfuturesbutinoptionscontracts.Anexampleofanoptionisacontractwhereweagree
thatIcanbuyricefromyouatanytimeoverthenextyear,atapricethatweagreerightnow
butIdon'thavetoifIdon'twantto.

Youcanimaginewhythiskindofcontractmightbeuseful.IfIamrunningabigchainof
hamburgerrestaurants,butIdon'tknowhowmuchbeefI'llneedtobuynextyear,andIam
nervousthatthepriceofbeefmightrise,wellallIneedistobuysomeoptionsonbeef.
Butthenthatleadstoaveryticklishproblem.HowmuchshouldIbepayingforthosebeef
options?Whataretheyworth?Andthat'swherethisworldchangingequation,theBlack
Scholesformula,canhelp.
"Theproblemit'stryingtosolveistodefinethevalueoftheright,butnottheobligation,tobuya
particularassetataspecifiedprice,withinorattheendofaspecifiedtimeperiod,"says

ProfessorMyronScholes,professoroffinanceattheStanfordUniversityGraduateSchoolof
BusinessandofcoursecoinventoroftheBlackScholesformula.
TheyoungScholeswasfascinatedbyfinance.Asateenager,hepersuadedhismothertoset
upanaccountsothathecouldtradeonthestockmarket.Oneoftheamazingthingsabout
Scholesisthatthroughouthistimeasanundergraduateandthenadoctoralstudent,hewas
halfblind.Andso,hesays,hegotverygoodatlisteningandatthinking.
Whenhewas26,anoperationlargelyrestoredhissight.Thenextyear,hebecameanassistant
professoratMIT,anditwastherethathestumbledupontheoptionpricingpuzzle.
Onepartofthepuzzlewasthisquestionofrisk:thevalueofanoptiontobuybeefatapriceof
say$2(1.23)akilogrampresumablydependsonwhatthepriceofbeefis,andhowtheprice
ofbeefismovingaround.

Buttheconnectionbetweenthepriceofbeefandthevalueofthebeefoptiondoesn'tvaryina
straightforwardwayitdependshowlikelytheoptionistoactuallybeused.Thatinturndepends
ontheoptionpriceandthebeefprice.Allthevariablesseemtobetangledupinanimpenetrable
way.
Scholesworkedontheproblemwithhiscolleague,FischerBlack,andfiguredoutthatifIown
justtherightportfolioofbeef,plusoptionstobuyandsellbeef,Ihaveadeliciousandtotallyrisk
freeportfolio.SinceIalreadyknowthepriceofbeefandthepriceofriskfreeassets,bylooking
atthedifferencebetweenthemIcanworkoutthepriceofthesebeefoptions.That'sthebasic
idea.Thedetailsarehugelycomplicated.
"Itmighthavetakenusayear,ayearandahalftobeabletosolveandgetthesimpleBlack
Scholesformula,"saysScholes."Butwehadtheactualunderlyingdynamicswaybefore."
TheBlackScholesmethodturnedouttobeawaynotonlytocalculatevalueofoptionsbutall
kindsofotherfinancialassets."Wewerelikekidsinacandystoryinthesensethatwe
describedoptionseverywhere,optionswereembeddedineverythingthatwedidinlife,"says
Scholes.
ButBlackandScholesweren'ttheonlykidsinthecandystore,saysIanStewart,whosebook
arguesthatBlackScholeswasadangerousinvention.

"Whattheequationdidwasgiveeveryonetheconfidencetotradeoptionsandveryquickly,much
morecomplicatedfinancialoptionsknownasderivatives,"hesays.
Scholesthoughthisequationwouldbeuseful.Hedidn'texpectittotransformthefaceoffinance.
Butitquicklybecameobviousthatitwould.
"Aboutthetimewehadpublishedthisarticle,that's1973,simultaneouslyorapproximatelya
monththereafter,theChicagoBoardOptionsExchangestartedtotradecalloptionson16
stocks,"herecalls.
ScholeshadjustmovedtotheUniversityofChicago.Heandhiscolleagueshadalreadybeen
teachingtheBlackScholesformulaandmethodologytostudentsforseveralyears.
"ThereweremanyyoungtraderswhoeitherhadtakencoursesatMITorChicagoinusingthe
optionpricingtechnology.Ontheotherhand,therewasagroupoftraderswhohadonlyintuition
andpreviousexperience.Andinaveryshortperiodoftime,theintuitiveplayerswereessentially
eliminatedbythemoresystematicplayerswhohadthispricingtechnology."
Thatwasjustthebeginning.
"By2007thetradeinderivativesworldwidewasonequadrillion(thousandmillionmillion)US
dollarsthisis10timesthetotalproductionofgoodsontheplanetoveritsentirehistory,"says
Stewart."OK,we'retalkingaboutthetotalsinatwowaytrade,peoplearebuyingandpeopleare
sellingandyou'readdingitallupasifitdoesn'tcancelout,butitwasahugetrade."
TheBlackScholesformulahadpassedthemarkettest.Butasbanksandhedgefundsrelied
moreandmoreontheirequations,theybecamemoreandmorevulnerabletomistakesorover
simplificationsinthemathematics.

"Theequationisbasedontheideathatbigmovementsareactuallyvery,veryrare.Theproblem
isthatrealmarketshavethesebigchangesmuchmoreoftenthatthismodelpredicts,"says
Stewart."Andtheotherproblemisthateveryone'sfollowingthesamemathematicalprinciples,
sothey'reallgoingtogetthesameanswer."
Nowthesewereknownproblems.Whatwasnotclearwaswhethertheproblemsweresmall
enoughtoignore,orwellenoughunderstoodtofix.Andtheninthelate1990s,tworemarkable
thingshappened.

"TheinventorsgottheNobelPrizeforEconomics,"saysStewart."Iwouldarguetheythoroughly
deservedtogetit."
FischerBlackdiedyoung,in1995.Whenin1997ScholeswontheNobelmemorialprize,he
shareditnotwithBlackbutwithRobertMerton,anotheroptionpricingexpert.
Scholes'workhadinspiredagenerationofmathematicalwizardsonWallStreet,andbythis
stagebothheandMertonwereplayersintheworldoffinance,aspartnersofahedgefundcalled
LongTermCapitalManagement.
"Thewholeideaofthiscompanywasthatitwasgoingtobaseitstradingonmathematical
principlessuchastheBlackScholesequation.Anditactuallywasamazinglysuccessfulto
beginwith,"saysStewart."Itwasoutperformingthetraditionalcompaniesquitenoticeablyand
everythinglookedgreat."
Butitdidn'tendwell.LongTermCapitalManagementraninto,amongotherthings,theRussian
financialcrisis.Thefirmlost$4bn(2.5bn)inthecourseofsixweeks.Itwasbailedoutbya
consortiumofbankswhichhadbeenassembledbytheFederalReserve.Andatthetimeit
wasaverybigstoryindeed.ThiswasallhappeninginAugustandSeptemberof1998,lessthan
ayearafterScholeshadbeenawardedhisNobelprize.

StewartsaysthelessonsfromLongTermCapitalManagementwereobvious."Itshowedthe
dangerofthiskindofalgorithmicallybasedtradingifyoudon'tkeepaneyeonsomeofthe
indicatorsthatthemoreconventionalpeoplewoulduse,"hesays."They[LongTermCapital
Management]werecommitted,prettymuch,tojustploughingaheadwiththesystemtheyhad.
Anditwentwrong."
Scholessaysthat'snotwhathappenedatall."Ithadnothingtodowithequationsandnothingto
dowithmodels,"hesays."Iwasnotrunningthefirm,letmebeveryclearaboutthat.Therewas
notanabilitytowithstandtheshockthatoccurredinthemarketinthesummerandfalloflate
1998.Soitwasjustamatterofrisktaking.Itwasn'tamatterofmodelling."

Thisissomethingpeoplewerestillarguingaboutadecadelater.WasthecollapseofLongTerm
CapitalManagementanindictmentofmathematicalapproachestofinanceor,asScholessays,
wasitsimplyacaseoftraderstakingtoomuchriskagainstthebetterjudgementofthe
mathematicalexperts?
TenyearsaftertheLongTermCapitalManagementbailout,LehmanBrotherscollapsed.And
thedebateoverBlackScholesandLTCMisnowabroaderdebateovertheroleofmathematical
equationsinfinance.
IanStewartclaimsthattheBlackScholesequationchangedtheworld.Doeshereallybelieve
thatmathematicscausedthefinancialcrisis?
"Itwasabuseoftheirequationthatcausedtrouble,andIdon'tthinkyoucanblametheinventors
ofanequationifsomebodyelsecomesalongandusesitbadly,"hesays.
"Anditwasn'tjustthatequation.Itwasawholegenerationofothermathematicalmodelsandall
sortsofothertechniquesthatfollowedonitsheels.Butitwasoneofthemajordiscoveriesthat
openedthedoortoallthis."
BlackScholeschangedthecultureofWallStreet,fromaplacewherepeopletradedbasedon
commonsense,experienceandintuition,toaplacewherethecomputersaidyesorno.
ButisitreallyfairtoblameBlackScholesforwhatfollowedit?"TheBlackScholestechnology
hasveryspecificrulesandrequirements,"saysScholes."Thattechnologyattractedorcaused
investmentbankstohirepeoplewhohadquantitativeormathematicalskills.Iacceptthat.They
thendevelopedproductsortechnologiesoftheirown."
Notallofthosesubsequenttechnologies,saysScholes,weregoodenough."[Some]had
assumptionsthatwerewrong,ortheyuseddataincorrectlytocalibratetheirmodels,orpeople
whoused[the]modelsdidn'tknowhowtousethem."
Scholesarguesthereisnogoingback."Thefundamentalissueisthatquantitativetechnologies
infinancewillsurvive,andwillgrow,andwillcontinuetoevolveovertime,"hesays.
ButforIanStewart,thestoryofBlackScholesandofLongTermCapitalManagementisa
kindofmoralitytale."It'sverytemptingtoseethefinancialcrisisandvariousthingswhichledup
toitassortoftheclassicGreektragedyofhubrisbegetsnemesis,"hesays.
"Youtrytofly,youflytooclosetothesun,thewaxholdingyourwingsonmeltsandyoufalldown
totheground.Mypersonalviewisthatit'snotjusttemptingtodothatbutthereisactuallya
certainamountoftruthinthatwayofthinking.Ithinkthebankers'hubrisdidindeedbeget
nemesis.Butthebigproblemisthatitwasn'tthebankersonwhomthenemesisdescendedit
wastherestofus."
AdditionalreportingbyRichardKnight

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