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.

Related posts:

  1. Henry Blodget, Michael Lewis, and Vampires
  2. Michael Lewis: D.F.A. Rules!
  3. Michael Lewis on Subprime Mortgages
  4. Michael Lewis on Subprime: The Poor are Sharks
  5. Note to Michael Lewis: Get in Line for Citi, Buddy

Comments

  1. nick gogerty says:

    for extreme events use Gott Theory, it helps slim those fat tails.
    http://nickgogerty.typepad.com/designing_better_futures/2007/07/predict-anythin.html