I have a couple of points on Cecil’s most amusing (“let a professional help you out,” indeed) column on a couple (fission and Chicago School economics) of the glorious achievements of UofC affiliates (http://chicago.straightdope.com/sdc20090115.php).
First, what is with Mr. James T. Struck and his honorifics? “James T. Struck, BA, BS, AA, CNA, MLIS?” Bachelor of Arts, Bullshit, Alcholics Anonymous, Certifed Nurse’s Assistant and Master of Living in Sin, right?
Second, the Black-Scholes option pricing formula is not what caused problems for Long Term Capital Management or the current markets. Not in itself. Not exactly. Yes, over-reliance on too complex mathematical formulas to price derivatives while ignoring correlative risks and, you know, reality, is a bad thing. But, the Black-Scholes formula itself, appplied to stock options, serves a useful function and is endorsed by the SEC.
The SEC requires the top executives of public companies to disclose their compensation in proxy statements. How do you disclose the value of options? An example: a stock option issued as compensation is typically a right to buy shares at $100 any time during the next 10 years, where the price of the stock on the date of issuance is $80. The executive is suppposed in be incented by this to improve the stock price so that he can exercise the option for a profit. However, the stock price may never reach $100 (in which case it will never be exercised) or the executive may never have the $100 to exercise the option (simplified–there are often cashless exercise rights).
So, for a long time, executives took the position that options couldn’t be valued and option value had no place in compensation disclosure–even if the stock is at $99 and the option still has 9 years to run.
Failing to disclose potential option value was misleading to shareholders. Various suggestions were made–assume an annual 5%/10% increase in stock price, etc. The Black-Scholes formula solves this problem and results in better disclosure to shareholders of the bloated compensation packages of corporate America’s fattest cats.
So, the formula itself: NOT bad, for exemplary and theoretical purposes.
Using related formulas to actually buy and sell derivatives on a market-wide basis: Bad.
Even more flavors of Bad: buying and selling financial instruments created from mathematical models too complicated for any one but your pusher from Citigroup/Bear Stearns/etc. to understand. Never let anyone who implies that you are too stupid to grasp the details of a bond or annuity sell you anything.