The subprime crisis and the subsequent cascading effect to other credit instruments could have one single origin: the total failure of the portfolio insurance system and the underlying mathematical model that powered it, The Black-Scholes equation. To make it short (so to speak), the model applied to a portfolio of any kind of securities, was supposed to limit the effect of a market drop through the use of options. Except that, when the real crash arises, the model no longer works and it added fuel to the panic it was supposed to prevent. In this excellent piece of explanatory journalism, Michael Lewis (well know author of The New New-thing or Poker’s Liar), details the black-hole equation. The short version: the Black-Scholes formula relies wrongly on the past volatility to predict the future. It only works when things are stable…
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