My cousin is a huge gossiper about ‘theories’. You know, that person who says something large has happened under complete discretion that has transformed our world. So this blog has been inspired by her; I’m going to tell you a story but I will only cover the main points. Then you decide if it’s real or garbage.
It was during the 16th Century when the world was introduced to financial institutions such as the Stock Exchange and Banks. Many merchants wanted to start huge businesses but lacked the capital to do so. So investors co-operated together and became business partners to form joint stock companies. This idea made it possible to become a multi million dollar business and England did not ignore the opportunity to build the London Stock Exchange.
As institutions grew, so did the financial methods. We were introduced to derivatives (not the mathematical kind). It’s basically an agreement between two parties that depends only on the value of an asset, not the sales of goods and services. So there are all kinds of derivatives such as Options or Bonds and boy, were they taking off! In fact, by the 20th Century, advanced derivatives were in play and people needed mathematical algorithms to help them calculate the value of a derivative.
Mathematical Algorithms such as “The Black Scholes” were being relied on more and more. The problem is as we all know in Mathematics, our formula’s only work if we make some assumptions beforehand about the data. The Black Scholes calculated the value of the derivative but it makes huge assumptions such as, ‘No transaction costs involved’ and ‘The volatility is constant’, i.e. your risk never changes. I’m not a financial expert but doesn’t this sound odd?
Indeed, the 2008-2009 market crash came along. House prices were falling, people could not pay back their loans, banks and lenders were going bust (as people could not pay them back) and we fell into a spiral of downfall. But what caused the crash?
- Herd behavior – People were so confident in their house prices increasing that others started to follow, thinking it was the road to wealth
- Traders did not appreciate the risks they were taking, relying simply on models that they felt were infallible
- Traders stopped looking at the fundamentals, checking if they matched with their models
So did mathematics cause the crash?
Personally, i don’t think so. Its important to realize that the Maths never lie, they give you results that are based on certain data and assumptions. The traders are to blame for the crash in my opinion. What are your thoughts?