It was the holy grail of investors. The Black-Scholes equation, brainchild of economists Fischer Black and Myron Scholes, provided a rational way to price a financial contract when it still had time to run. It was like buying or selling a bet on a horse, halfway through the race. It opened up a new world of ever more complex investments, blossoming into a gigantic global industry. But when the sub-prime mortgage market turned sour, the darling of the financial markets became the Black Hole equation, sucking money out of the universe in an unending stream.
And because the derivatives markets were based on Black Scholes and we had a financial crisis, thus the financial crisis came from the use (more accurately, misuse) of Black Scholes.
Except, well, the financial crisis wasn\’t a crisis in derivatives. It was a crisis in housing finance and the securitization of said mortgages. Which aren\’t to the first order, derivatives and which aren\’t priced using Black Scholes.
The maths is fine. It\’s the knowledge of the financial world that\’s a little off.
Even where the crisis was arguably about derivatives (ie, where the value of x depends upon the underlying value of y), credit default swaps and AIG, the problem wasn\’t that they had used B-S to value them. It was that they used bull shit to do so and simply never considered the possibility of a fall in the value of y. That is, they didn\’t value them as options, but as insurance contracts that they would never have to pay out on.