A very interesting article on the BBC – the financial formula that ruined the world.
Well, that’s a bit sensationalist, but it’s a formula that allowed intuition to be taken out of “options” trading and computers to move in. And with the “understanding” of the maths of futures there was a move into more and more complex derivatives.
Around 1970 Professor Myron Scholes and his colleague Fischer Black worked out a formula so that if you have the right combination of a commodity and options to buy and sell that commodity you end up with a “risk-free” portfolio.
“We were like kids in a candy story in the sense that we described options everywhere, options were embedded in everything that we did in life,” said Scholes.
And so faster and faster trading of derivatives followed – by 2007 $US1 quadrillion in derivatives were being traded: 10 times the total production of goods in human history.
But with faster trading and more complex derivatives came problems. Traders were more vulnerable to simplifications and mistakes. And with everyone using very similar formulae, in the event of a large movement unpredicted by the formula everyone gets the same sell result…
Scholes received the Nobel prize for economics in 1997; in 1998 his hedge fund crashed. The firm lost $4bn in 6 weeks with the Russian financial crash, but hedge funds and banks didn’t change course. 10 years later it was Lehman Brothers.
Professor Ian Stewart of Warwick Uni describes it as a morality tale:
“It’s very tempting to see the financial crisis and various things which led up to it as sort of the classic Greek tragedy of hubris begets nemesis,” he says.
“You try to fly, you fly too close to the sun, the wax holding your wings on melts and you fall down to the ground. My personal view is that … the bankers’ hubris did indeed beget nemesis. But the big problem is that it wasn’t the bankers on whom the nemesis descended – it was the rest of us.”
So we end up with the debt, bailouts and pain; and meanwhile the bankers bonuses keep rolling on in and executive salaries keep rising…