Sorry But Black-Scholes Did Not Cause the Financial Crisis

The UK Guardian carries a remarkably silly story on the Black-Scholes options pricing formula called “The mathematical equation that caused the banks to crash.” I honestly don’t know where to begin, but claiming that the Black-Scholes options pricing model caused the financial crisis is economically illiterate.

The best thing I can say about the story is that at one point, the text directly contradicts the headline:

The equation itself wasn’t the real problem. It was useful, it was precise, and its limitations were clearly stated. It provided an industry-standard method to assess the likely value of a financial derivative. So derivatives could be traded before they matured. The formula was fine if you used it sensibly and abandoned it when market conditions weren’t appropriate. The trouble was its potential for abuse.

That’s like saying subtraction caused the crisis. Well, not subtraction directly of course. But subtraction was abused.

Look, options have been around for a long time. This site has an image of an options contract from 1959. Options were around decades before 1973 when the Black-Scholes formula came about. So why didn’t options cause a crisis before 2007?

The article seems to blame the crisis on all financial models. But a financial model is only as good as the data you put in. If you put in garbage, well…that’s exactly what you get. It wasn’t the fault of modeling that their designers didn’t assume home prices would or could drop by 20%.

We can point to the incredible growth of Credit Default Swaps. The CDS market grew from $3.7 trillion in notional value in 2003 to $62.2 trillion by 2007. But again, can that be blamed on a model?

Instead, it’s far more interesting to ask what was driving the demand. Even if you make CDS’s illegal, a lot of folks out there wanted them. Why? Unfortunately, the answer isn’t so easy. The financial crisis was complicated and it had many players.

Barry Ritholtz collected a list of culprits whose actions led to the financial crisis. You probably won’t be surprised to see that Alan Greenspan comes in at #1. And Black-Scholes doesn’t even make the top 25.

Posted by on February 13th, 2012 at 12:20 pm


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