I went to see The Power of Yes yesterday. It is a very good explanation of the financial crisis as explained by a playwright – David Hare. I recommend it – the two hours flew by. However there was one small item I worried about. There was a comment about ‘Monte-Carlo methods’ being used by AIG which got a cheap laugh which I thought unfair. Monte Carlo methods are not about gambling – they are about minimising risk.
To explain (please bear with me I will get to the point):
The formula used to price a lot of the securities that caused the problem is the Black-Scholes formula – which one of the actors wrote up on a board. But the statement was made that it ‘predicts’ the future. Which is doesn’t; unless a statement like ‘if you flip a coin if will be heads 50% of the time’ can be said to be predicting the future. The Black-Scholes formula just says that if you assume that security prices vary at random then the price in x days time will be within certain limits y and z, except in very exceptional circumstances.
There are two assumptions built into this which are questionable. (more…)
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