I gave a speech about Fischer Black, and all I got was this not-at-all-lousy T-shirt

I think this T-shirt is a little unfair. I actually had Fisher Black for capital markets at MIT. Fisher was quite open to inefficient markets, and when I saw him at Goldman after he left MIT, I said "Fisher what are you doing here?, you taught us the markets were efficient.". He said, "Jack, I found a few inefficiencies".

He also wrote a paper called, "Yes Virginia there is hope" about the Value Line system which he said did in fact out perform the market on a consistent basis for a long period of time.

The old Black-Scholes model we've seen that it doesn't work in puts and calls if the market is efficient at pricing an option there'd be no arbitrage opportunities. The only thing that has narrowed said opportunities is computerized trading. In the market: all models are wrong!

I just finished the Lowenstein book on the rise and fall of LTCM. A couple of observations based on that reading, and current economic events.

First, models, such as Black Scoles, work...except when they don't. Models can be a tool for analysis, but using models to predict future performance is like predicting the weather 10 days out. There are probabilities, but no certainty.

Second, speculators and arbitragers will use the models and the economists who created them to justify their own behavior. Lessons from the LTCM disaster are that people like the partners in LTCM will bring in people like Merton and Scoles to enhance their credibility with investors, distort the models to suit their own ends, ignore the advice of the professors, and the professors will let them get away with it. Maybe because it allows them to get out of their ivory tower and test theories in the real world laboratory or because the partners make them a lot of money, or they get to run with a fast crowd.

Third, the professors will defend their models even when the models are shown to be less than reliable. Like I said, sometimes Black Scoles does price a derivative accurately.... when all the assumptions implicit in Black Scoles are in place. Take away a couple assumptions, throw in herd mentality, and you have a serious problem. The spreads did eventually converge, but by the time they did, LTCM was out of money. Ten years later, Scoles still defends derivatives carte blanche. In a recent article in The Economist, Scoles is quoted, saying that attempts to regulate derivatives is a Luddite response.

Fourth, excuse, me that was "Nobel prize laureate Myron Scoles" Maybe, just maybe, the Nobel committee does not really know all that much about economics in the real world. Where is it written that we should give the Nobel committee that much credibility? But the press still keeps saying "Nobel Prize winning economist X" and for some reason that gives people like Krugman more influence. Krugman gets an award for studying trade patterns, and all of a sudden he is on every TV channel being quoted as an expert on everything economic, and some things political. Sorry Mr Krugman, but there are limits to your economic knowledge. Michael Debakey may have known heart surgery, but I doubt if he could have done much about my allergies.

Seriously, I just about fell out of my chair when I saw the Economist quoting Scoles. Based on what I saw in the Lowenstein book, Scoles ignored the real world, when he should have been pressuring the partners at LTCM into understanding the models do not always work. I think he made some feeble attempts, but he was ineffective at curbing disaster. Models work a lot better in the hard sciences.

Also, given the choice between pursuing their own narrow interests, and taking a long view as to what is best for the economy, the guys at Goldman Sachs will savagely pursue their own interests. They got privileged access to LTCM's books, then made trades that maybe used that information. Also, they have better lawyers and spokespeople to explain their behavior.

Last......what is really scary about reading the Lowenstein book is that we don't learn when the lesson is inconvenient to what we want to do. Wall Street, the Fed, and the Treasury ignored the lessons of the 1987 crash, the problems in the early nineties.
Within a year after the LTCM crisis, Congress passed Gramm Leach Bliley, Brooksley Born was being brow beaten by Gramm, Larry Summers, Greenspan, et al because she suggested that CDS should be regulated. Policy makers ignored the lesson because it did not fit their view of the way they wanted the world to be. They wanted to believe that everybody on Wall Street could be trusted, that the models always worked, that the Wall Street guys with MIT degrees and Harvard degrees were so much smarter than the rest of us. Maybe they are, but that does not mean they have good judgment when it comes to what is best for all of us.

And we still ignore the lessons today. Some sectors are slowly recovering from the disaster, others are just hanging on hoping things get better. And yet the policymakers waffle on enacting reform that will prevent future disasters.

As for me..... I actually trust the weatherman's forecasts a lot further than Nobel Prize winning economists, because their forecasts will be based on the history of weather in Iowa. Yes, every so often we have a mild early December, but I will make sure I have my winter clothes ready.

While I agree with you Randy the model knows how to price things like CDO's on upward trend it does not know how to unwind them in price in a downward trend I think we've all seen this? And, like you said it deal in probabilities but downward negative probabilities can lead to some serious wield and often wrong information. The lack od they theory could be the absence of complex conjugation between them?

Link to said semi-conjugation

http://encyclopedia.thefreedictionary.com/Complex+derivative

There's now a growing field called econophysics, and is making some impressive results proving a lot of these market "theories" wrong. To the dismay of economists I'm sure. I used the link because I think the system they used is no homomorphic in its structure, so complex conjugation seems to be in order?