Go pour yourself a glass of milk, and add a few spoonfuls of Nestle Quik to it. Watch the grains of chocolate-flavored sugar float around through the liquid. Does this resemble the stock market to you? No? Congratulations, you're smarter than most of Wall Street's biggest asset managers.
Derivatives, particularly those menacing credit-default swaps, are a big part of the credit crisis. Nobody knows how much they're worth anymore! Probably nothing! Why? Because, like they have done roughly 14 times since 1987, Black-Scholes and other stochastic pricing models have proven to be fundamentally flawed.
Back to your glass of chocolate milk. Particles - the Quik -in solution - the milk - diffuse in a geometric, stochastic process called Brownian Motion. Or at least, that's how Physicists predict the movements of individual particles and the group collectively. Some so-called geniuses, Fischer Black, Robert Merton, and Myron Scholes, decided that markets moved like Quik in a glass of milk. This led to the Black-Scholes pricing model, and to the Capital Assets Pricing Model. Both are commonly used in determining the valuation of assets. These guys won a Nobel Prize for this. Seriously.
Unfortunately, Black-Scholes and CAPM are as flawed as chocolate milk is delicious. For a lot of boring mathematical/philosophical reasons! But you can skip to the proof in the pudding: Myron Scholes and Robert Merton were working at LTCM when it died. And built most of its credit-spread derivative trading schemes out of their Brownian hypothesis. Fun fact: LTCM's horrific collapse was the last big market event to almost thrust us into disaster!
They teach Black-Scholes and CAPM in college. For a laugh, when they test you on it, hand them a copy of When Genius Failed. You won't pass, because teachers don't get jokes.
The best debunking I've ever read was written by Benoit Mandelbrot, most commonly known for the Mandelbrot set - a fractal. He makes a compelling argument that the market is more chaotic than Brownian, and assets would be best valued by a fractal-based analysis in The Mis-Behavior of Markets. Check it out. It's not a math tome, and there are better debunkings, but this one's relatively easy to read and not nearly as dry as others. If you care about the mathematical assumptions that contributed to this crisis I suggest it.
9.22.2008
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