Value Investing World: Inside Wall Street's Black Hole by Michael Lewis

In my opinion, one should just file Black-Scholes in the same category as the Efficient Market Hypothesis/Theory, the Capital Asset Pricing Model (CAPM), Beta, etc. That category, to borrow a term from Charlie Munger, should be labeled TWADDLE. But let's hope 99+% of colleges/universities continue to teach them so that value investors can have some limit to competition.

For years, investors have relied on a complex formula to manage risk. But what happens if the Black-Scholes model is wrong—and we're in bigger trouble than ever?
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Oddly, this failure of financial theory didn't lead Wall Street to question Black-Scholes in general. "If you try to attack it," says one longtime trader of abstruse financial options, "you're making a case for your own unintelligence." The math was too advanced, the theorists too smart; the debate, for anyone without a degree in mathematics, was bound to end badly. But after the crash of 1987, individual traders at big Wall Street firms who sold financial-disaster insurance must have smelled a rat. Across markets—in stocks, currencies, and bonds—the price of insuring yourself against financial disaster rose. This rise in prices and the break with Black-Scholes reflected two new beliefs: one, that huge price jumps were more probable and likely to be more extreme than the Black-Scholes model assumed; and two, that you can't manufacture an option on the stock market by selling and buying the market itself, because that market will never allow it. When you most need to sell—or to buy—is exactly when everyone else is selling or buying, in effect canceling out any advantage you once might have had.

"No one believes the original assumptions anymore," says John Seo, who co-manages Fermat Capital, a $2 billion-plus hedge fund that invests in catastrophe bonds—essentially bonds with put options that are triggered by such natural catastrophes as hurricanes and earthquakes. "It's hard to believe that anyone—yes, including me—ever believed it. It's like trying to replicate a fire-insurance policy by dynamically increasing or decreasing your coverage as fire conditions wax and wane. One day, bam, your house is on fire, and you call for more coverage?"

THE PROBLEM

This is interesting: The very theory underlying all insurance against financial panic falls apart in the face of an actual panic. A few smart traders may have abandoned the theory, but the market itself hasn't; in fact, its influence has mushroomed in the most fantastic ways. At the end of 2006, according to the Bank for International Settlements, there were $415 trillion in derivatives—that is, $415 trillion in securities for which there is no completely satisfactory pricing model. Added to this are trillions more in exchange-traded options, employee stock options, mortgage bonds, and God knows what else—most of which, presumably, are still priced using some version of Black-Scholes. Investors need to believe that there's a rational price for what they buy, even if it requires a leap of faith. "The model created markets," Seo says. "Markets follow models. So these markets spring up, and the people in them figure out that, at least for some of it, Black-Scholes doesn't work. For certain kinds of risk—the risk of rare, extreme events—the model is not just wrong. It's very wrong. But the only reason these markets sprang up in the first place was the supposition that Black-Scholes could price these things fairly."

Black-Scholes didn't work; trillions of dollars' worth of securities may have been priced without regard to the possibility of crashes and panics. But until very recently, no one has bitched and moaned about this problem too loudly. Lay folk might harbor private misgivings about the clergy, but as lay folk, they are reluctant to express them. Now, however, as the subprime market unravels, the beginnings of a revolt against the church seem to be taking shape.

One of the revolt's leaders is Nassim Nicholas Taleb, the bestselling author of The Black Swan and Fooled by Randomness and a former trader of currency options for a big French bank. Taleb can precisely date the origin of his own personal gripe with Black-Scholes: September 22, 1985. On that day, central bankers from Japan, France, Germany, Britain, and the United States announced their intention to torpedo the U.S. dollar—to reduce its value in relation to the other countries' currencies. Every day, Taleb received a list of his trading positions from his firm and a matrix describing his risks. The matrix told him how much money he stood to make or lose, given various currency fluctuations. That September 22, when the central bankers announced their plan to lower the dollar's value, he made money but didn't know it. "I didn't know what my position was," he says, "because the movement was outside the matrix they'd given me." The French bank's risk-analysis program assumed that a currency crash of this magnitude would occur once in several million years and therefore wasn't worth considering.

Taleb made a killing that day, but it wasn't thanks to a grand plan and it wasn't happy money. "People in dark suits started coming from Paris," he says. "They said that the only way I could have made that much was to have taken far too much risk." But he hadn't. They had simply failed to account for the true nature of risk in financial markets. "Then I started looking at the history of markets," he says. "And I saw that these sorts of things happened all the time." Taleb became obsessed with the way prices in the options market, based on the famous Black-Scholes model, underestimated the risk of extreme and rare events. He set up his trading to profit from such events by buying up disaster insurance that would, according to Black-Scholes, be considered overpriced. When October 19, 1987, arrived, he was prepared. "Ninety-seven percent of all the returns I ever made as a trader, I made on that day," he says.

THE SOLUTION

In the past two years, Taleb has co-authored a pair of papers that have appeared in the sort of academic journals that originally published the Black-Scholes model. He and his co-author attack the model head-on in its own language (math), and as much as call for a retraction of the Nobel Prize awarded to Myron Scholes and Robert Merton for their work in creating the model. "This is what I'm saying to Merton and Scholes," Taleb says. "You guys are just parasites. You're not bringing anything useful to the market. You are lecturing birds on how to fly. You're watching them fly. And then you're taking credit for it."

He's saying more than that, actually. He's saying that the academics, in lecturing the birds, have made flying more difficult.

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