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February 21, 2008
Michael Lewis: Black-Scholes Deemed Bad for Health
Typically worth-reading Michael Lewis piece in the March issue of Portfolio magazine, this time on the subject of option theory and Black-Scholes pricing models. The gist: Market catastrophes happen more often than such models suggest, and, by acting as if the model holds, when it doesn't, at least now when we need it, we make things worse.
"No one believes the original assumptions anymore," says John Seo, who co-manages Fermat Capital, a $2 billion-plus hedge fund that invests in catastrophe bonds—essentially bonds with put options that are triggered by such natural catastrophes as hurricanes and earthquakes. "It's hard to believe that anyone—yes, including me—ever believed it. It's like trying to replicate a fire-insurance policy by dynamically increasing or decreasing your coverage as fire conditions wax and wane. One day, bam, your house is on fire, and you call for more coverage?"
Read the whole thing.
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for extreme events use Gott Theory, it helps slim those fat tails.
http://nickgogerty.typepad.com/designing_better_futures/2007/07/predict-anythin.html