This article was taken from the December 2011 issue of Wired magazine. Be the first to read Wired's articles in print before they're posted online, and get your hands on loads of additional content by subscribing online.
King Midas wished that everything he touched would turn to gold. His wish was granted, and for a time it all went swimmingly -- until he touched his beloved daughter.
It was 40 years ago that the world's financial sector discovered a mathematical equation that it thought was an equally sure-fire method for making money. And, like Midas's touch, it worked brilliantly -- at first. It underpinned the main engine of recent growth in the financial sector: derivatives. But, again, the outcome wasn't happy.
Derivatives are not money. They are investments in investments.
The simplest derivatives, options, are contracts to buy or sell some commodity at a specified date for a specified price. But how could you place a sensible value on an option before it fell due?
That would allow a trade in options to become possible. In 1973 Fischer Black and Myron Scholes solved the problem using the Black-Scholes Equation. This expresses how fast the price of the derivative is changing in terms of the current price, how sensitive it is to the stock price, and how it accelerates.
The equation is based on a number of financial assumptions and it works very effectively under normal conditions -- it won Scholes a share of the 1997 Nobel Prize in Economics. As confidence grew, many bankers forgot the assumptions that made the equation valid.
It became known as the Midas formula. But they had forgotten how the story ended.
Ever-more complex financial instruments were invented, creating a booming quadrillion-dollar derivatives industry. But when the bankers finally began to ask themselves whether the equation could go wrong, they began to wonder what the real value of their holdings in derivatives was.
The result was a multitrillion-dollar financial crash whose more malign effects are still reverberating worldwide. But it wasn't the equation's fault. It did what it was designed to do. The fault lies with those who ignored its limitations.
This article was originally published by WIRED UK
