A Brief History of the Black-Scholes Formula
May 8, 2012
Here’s a story for the math inclined—the story of a formula that transformed the financial industry. BBC News describes “Black-Scholes: The Maths Formula Linked to the Financial Crash.” Writer Tim Harford stretches the tale back to 17th Century Japan, but the formula itself was developed in the early 1970s by Myron Scholes and Fischer Black. The problem it was created to solve? The valuation of options. As the write up understates, “the details are hugely complicated.”
After the formula was published, it took on a life of its own, eventually enabling the development of that confounding instrument, the derivative. The article tells us:
“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. . . .
“‘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 [author Ian] Stewart.”
. . . . And we all know how that story progressed. The article goes in depth into why widespread use of the Black Scholes Formula has caused so much trouble in the markets. The issue has sparked debate about not only this formula, but the role of equations in the stock market and the related reliance on computer-directed trading.
Is there any hope that one day investments will again be centered around building things (and jobs) rather than on placing bets? Nah, probably not.
Cynthia Murrell, May 8, 2012
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