Michael Lewis gets his nerd on in the March issue of Portfolio, wading into the Taleb vs Black-Scholes debate. But he actually seems to go even further than Taleb. Think of three levels of skepticism when it comes to the option market:
- The naive broker-dealer view: Black-Scholes enabled us to price options, and a large and efficient market is built on it.
- The Taleb view: Bachelier-Thorp (which predates Black-Scholes) enabled us to trade options, and a large and efficient market is built on it, and Black-Scholes is irrelevant.
- The Lewis view: Black-Scholes enabled us to price options, and a large market is built on it, and Black-Scholes is wrong, and so we’re all doomed.
Lewis blames a lot of things on Black-Scholes, including the housing bubble:
It wasn’t only big Wall Street firms, but a lot of small real estate speculators–otherwise known as homeowners–who, in effect, sold put options too cheaply against the risk of extreme, rare events. That many of these people literally live inside the investment that they’ve speculated on sharpens the pain but fails to drive home the point.
I’m not sure I follow this. In what sense is taking out a mortgage akin to selling a put option too cheaply? If anything, given the non-recourse nature of mortgages, it’s closer to buying a put than it is to selling one. And more generally, Lewis doesn’t persuade me that options prices in reality conform to Black-Scholes theory.
Lewis is right that if options were priced according to Black-Scholes, then we would all be doomed. But are they? Really? Taleb’s paper says that by "fudging and changing the tails and skewness by varying one parameter" in order to get Black-Scholes to accord with market reality, traders essentially render Black-Scholes moot anyway.
And personally I’m not worried about markets "for which there is no completely satisfactory pricing model," be they in options or anything else. After all, there’s no completely satisfactory pricing model for equities, either, and no one seems to be losing sleep over that.
Update: Taleb writes in the comments that "I fully agree with Michael Lewis". The idea I think is that without Black-Scholes we wouldn’t have portfolio theory, CAPM, or any of the other desiderata of financial markets which ultimately enabled the housing bubble to appear.