Home > Behavioural Economics, Financial Markets > The mathematical equation that caused the financial crisis?

The mathematical equation that caused the financial crisis?

February 17, 2012 Leave a comment Go to comments

The Black-Scholes equation (see below), named after economists Fisher Black and Myron Scholes, brought a new dimension to derivative trading on financial markets. It enable traders to price derivative contracts before they matured – The Guardian likened it to “buying or selling a bet on a horse, halfway through the race.” The equation itself wasn’t the problem as its limitations were clearly defined, however it was how it was used in the market that brought about the complications. The equation became the industry-standard way of assessing the value of derivatives before they matured but this also led to derivatives themselves becoming commodities that could be traded in their own right.

According to The Guardian, by 2007 the international financial system was trading derivatives valued at one quadtrillion dollars a year – 10 times the total value of all products made by the world’s manufacturing industries over the last century. The drawback of the equation was that it made things even more complicated and companies employed financial engineers (mathemeticians basically) to analyse the markets. However the system came unstuck when markets became irrational and reliability on the equation was lost.

Over the last century the later part of financial crises tend to have been caused by herd mentality. This makes markets extremely volatile to sudden booms and slumps in prices.

“By studying ecological systems, it can be shown that instability is common in economic models, mainly because of the poor design of the financial system. The facility to transfer billions at the click of a mouse may allow ever-quicker profits, but it also makes shocks propagate faster.”

However, the equation wasn’t the major cause of the financial crisis. There are other variables that were influential namely:

– regulatory framework did not keep pace with financial innovation
– predatory lending – enticing borrowers to enter into “unsafe” or “unsound” secured loans
– easy credit conditions – very low interest rates
– housing bubble – the average US house price increased by 124% between 1997-2006
– financial Institutions became highly leveraged, increasing their appetite for risky investments and reducing their resilience in case of losses

According to Ian Stewart in The Guardian:

“the system is too complex to be run on error-strewn hunches and gut feelings, but current mathematical models don’t represent reality adequately. Teh world economy needs an overhaul and requires more mathematics not less.”

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