Monday, January 5, 2009


So: what do I think about the "Black Swans versus Black-Scholes" dispute I tried to chronicle in yesterday's entry?

By way of answering, let me re-introduce you to Emanuel Derman. I mentioned him yesterday -- he was a co-author, with Taleb, of "The illusions of dynamic replication," the 2005 article that seems to have started the whole anti-Black-Scholes campaign.

Derman dropped out of the story then, because Taleb started shifting his line of attack and acquired new co-authors for the new approach.

But Derman, a one-time subatomic physicist, and the 2006 recipient of the Wilmott Award for Contributions to Quantitative Finance, has re-appeared. Now he shows up more as a defender of Black-Scholes than as a critic. See his New Years' Day blog comment on the Wilmott website.

So far as I understand these things: I think Derman is right. the Black-Scholes-Merton model was a real advance in the understanding of financial economics, one that has the benefit of being very clear about its simplifying assumptions. To oppose simplifying assumptions, after all, is to oppose a good deal more than this particular model for the pricing of stock options. It is to oppose a crucial step in the achievement of every major scientific advance on record.

And yes, I think with the anonymous recent poster at FT, that BSM has been on the whole a force for good in this crazy mixed-up world.

One intruguing sidebar to this controversy is the whole "teaching birds to fly" meme. Taleb and others on his side of the debate sometimes speak as if the idea of teaching birds to fly is inherently ridiculous, and if Black, Merton, and Scholes were trying to teach options traders to trade, describing methods the options traders already (instinctively?) possessed.

The linguist Noam Chomsky has invoked the same meme, as it happens, in his evaluation of primate-language research. Chomsky believes that langauge is a distinctively human attribute, that humans are hard-wired for it, and that the efforts to teach human language to other primates have failed in a predictable way, making this point. In an interview he gave in 1983 link, he said: "That's exactly what we should expect, I think. Why should we expect it? Because, if it turned out, contrary to what has so far been shown, if it turned out that apes really did have something like a capacity for human language, we would be faced with a kind of biological paradox. We would be faced with something analogous to, say, the discovery on a previously unexplored island that there is a species of bird with all the mechanisms for flight that has never thought of flying, until somebody comes along and trains it and says, look, you can fly. That's not impossible, but it's so unlikely that nobody would take the possibility very seriously."

Chomsky and Taleb, then, share the teaching-birds-to-fly meme.

But it seems to me, from either source, a bit presumptuous. There is nothing inherently absurd in teaching birds to fly. In fact, when I googled that phrase just now, I came up with this.

Birds are, it appears, taught how to fly, just as Elsa was taught how to be a free-ranging lion.

Cue the Born Free theme music please.


Jonathan said...

Great article.


Jonathan said...

Great article

Jonathan Shem Ur