Sunday, April 29, 2012

Black-Scholes: The maths formula linked to the financial crash

"Black-Scholes was first written down in the early 1970s but its story starts earlier than that, in the Dojima Rice Exchange in 17th Century Japan where futures contracts were written for rice traders. A simple futures contract says that I will agree to buy rice from you in one year's time, at a price that we agree right now.

"By the 20th Century the Chicago Board of Trade was providing a marketplace for traders to deal not only in futures but in options contracts. An example of an option is a contract where we agree that I can buy rice from you at any time over the next year, at a price that we agree right now - but I don't have to if I don't want to.

(...) "The Black-Scholes method turned out to be a way not only to calculate value of options but all kinds of other financial assets. "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," says Scholes.

"But Black and Scholes weren't the only kids in the candy store, says Ian Stewart, whose book argues that Black-Scholes was a dangerous invention.

""What the equation did was give everyone the confidence to trade options and very quickly, much more complicated financial options known as derivatives," he says." Read the article: Black-Scholes: The maths formula linked to the financial crash By Tim Harford, 27 April 2012 BBC