Taking Stock of Bonds

March 5, 2008

Black Scholes, or Black Holes?

The last year has challenged many notions about risk and how different segments of the global financial markets ought to interact. The relationships between fixed-income markets and equity markets have been upended as have beliefs about credit and inflation. Now some investors may be asking questions about an options-pricing model on Wall Street called Black-Scholes.
 
The Black-Scholes formula is a method of valuing stock options. The model was created by Fischer Black, Robert Merton and Myron Scholes. Merton and Scholes won the Nobel Prize in economic sciences for their work in 1997. In awarding the two the Nobel, the Royal Swedish Academy of Sciences said the Black-Scholes formula "paced the way for economic valuations in many areas" and "generated new types of financial instruments and facilitated more efficient risk management in strategy."
 
In the March edition of Portfolio magazine, Michael Lewis examines how some traders believe Black-Scholes is faulty. As Lewis points out, the methodology was not helpful in the October 1987 crash, but it was not called into question, perhaps because few wanted to engage in debate over the model. A trader in Lewis' article says that "if you try to attack it, you’re making a case for your own ignorance." One former currency trader, Nicholas Taleb, has attacked the model and called for the retraction of the Nobel Prize to Merton and Scholes. "Financial panics have become almost commonplace ... could this be because the financial system was built on an idea that badly underestimates the risk of catastrophes - and so conspires with human nature to create them?" Lewis asks in his report.
 
Lewis also notes that the model has led investors to believe they have a handle on complex financial risk and "by mispricing that risk, Black-Scholes encourages them to take more chances than they rationally should. The big Wall Street firms oddly enough are the most foolish in this regard."
 
The traders Lewis cites in his report may have a point. After all, what risk is there in checking and rechecking some of our assumptions about how we value and measure risk in financial markets? In the last year we have seen the Fed say the housing market's problems will not infect the broader economy -- they have, as any retailer will tell you -- and we have heard so-called specialists say that home prices won't fall on a national scale -- they have. And ratings held sacred are not worth much for some investors that held AAA second lien mortgage debt.