But usually the model performed very well, so as time passed and confidence grew, many bankers and traders forgot the model had limitations. Black had died by then, so he was ineligible. It makes everything go belly-up at the same time. Banks, hedge funds, and other speculators were soon trading complicated derivatives such as credit default swaps — likened to insuring your neighbour's house against fire — in eye-watering quantities. It may be rocket science, but magic it's not. The early success of Black-Scholes encouraged the financial sector to develop a host of related equations aimed at different financial instruments.
Soon, the banks followed them into increasingly speculative ventures.
The mathematical equation that caused the banks to crash
Derivatives created a booming global economy, but they also led to turbulent markets, the credit crunch, the near collapse of the banking system and the economic slump. Any mathematical model of reality relies on simplifications and assumptions. At the forefront of these efforts is complexity sciencea new branch of mathematics that models the market as a collection of individuals interacting according to specified rules. Despite its supposed expertise, the financial sector performs no better than random guesswork. The facility to transfer billions at the click of a mouse may allow ever-quicker profits, but it also makes shocks propagate faster. And it was the Black-Scholes equation that opened up the world of derivatives.