The mathematical equation that caused the banks to crash

[CHIMO]

It was the holy grail of investors. The Black-Scholes equation, brainchild of economists Fischer Black and Myron Scholes, provided a rational way to price a financial contract when it still had time to run. It was like buying or selling a bet on a horse, halfway through the race. 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.

http://www.guardian.co.uk/science/2012/feb/12/black-scholes-equation-credit-crunch

[eridani]

1. Very educational--thanks for posting n/t

[napoleon_in_rags]

2. "The Black-Scholes equation has its roots in mathematical physics"

"where quantities are infinitely divisible, time flows continuously and variables change smoothly."

Not even there. The 'ultraviolet catastrophe' was based on this idea of smooth continuous change, to fix it they had to come up with this idea of small discrete packets of energy. Beware the continuous, its always an approximation. It sounds like they have the right idea with this complexity theory, looking at things in terms of discrete individual actions.

[FreakinDJ]

3. E = Greed x All-Fucked-Up

Trading in intangible items should be outlawed

[SDjack]

5. Equation mis-stated?

Shouldn't the "All-Fucked-Up" variable be squared?

[FreakinDJ]

7. Right you are - my miscalculation

[izquierdista]

4. The equation itself wasn't the real problem.

I'm glad they got to that, although you had to get to the third paragraph to find it. And if you get to the bottom of the article, you find

The entire system is poorly understood and dangerously unstable. The world economy desperately needs a radical overhaul and that requires more mathematics, not less.

This is yet another example of why economics is in a pre-science stage. The Black-Scholes equation is merely the Fourier heat equation from 150 years earlier with price substituted for the variable of temperature. We're still trying to figure out how the heat equation works in meteorology, with different models coming up with different weather and climate forecasts; how can people think they have figured out prices, which have many more degrees of freedom?

[bemildred]

6. Well, it's a false model. economics is not physics, and it's not like physics either.

Most of all, it's not random, or even pseudo-random, what it is is chaotic, that is quasi-deterministic, but so complicated that it is not even in principle predictable.

And as you point out so well, even much of physics is far from well understood.

And so we have garbage in and garbage out.

[Demeter]

8. Economics needs more rules of law and less fancy-dancy fraud

But try to find an economist or politician or bankster who will agree.....crooks like the crooked way.

[bemildred]

9. Mumbo Jumbo still pays well. nt

[phantom power]

10. the problem wasn't ever equations, or MBSs...

the problem was massive, massive fraud: deliberately rating MBSs far far higher than there was any justification for, equations or otherwise. Deliberately blowing off proper paper trail of mortgage ownership, deliberately robo-sigining foreclosures, etc.

[bemildred]

11. +1.

The math was used as a deliberate smokescreen for the fraud, because it sure as hell is not good applied math, and any real mathematician would not touch such twaddle with a pole.

[truedelphi]

12. Thank you for this information. However, there was an opposing view

At the time of a mini crash back in late 10 (or maybe it was 2009) and it is far more sinister as it is far more everyday in its occurrence:

http://www.facebook.com/photo.php?fbid=1225086642415&set=a.1230415895643.27680.1686499927&type=3&theater

[Sam1]

13. Two very good and readable books are

Emanuel Derman's "My Life as a Quant" and "Models behaving Badly.

It wasn't the equations that almost destroyed the economy it was their misuse that was the cause. It was the lack of regulation, supervision, and effective punishment that enabled the banksters and traders to cause the damage and they did it for their own personal enrichment using the banks as tools of fraud.

It was among others, O'bama, saying on the David Letterman show that the bankers had done terrible things that unfortunately were legal that are responsible. The regulators should have been making criminal referrals and the Justice Deptment should have been prosecuting based on the referrals. In my opinnion the major banks were and still are control frauds. See Bill Black's blogging over at http://www.neweconomicperspectives.org. on control frauds.

There was, in my opinion a lot for fraud, forgery, and perjury going on, and still going on