The Math Behind the Meltdown

[Draggingtree]

American Interest:

From the January/February 2013 issue:

The Math Behind the Meltdown

Chris Taylor

The financial product known as an “option” matters. Many people never hear of one on an average day, but they are everywhere. Ask a modern participant in or scholar of finance about options, and he will readily tell you that the world he lives in is inconceivable without them. Ask anyone investigating what went wrong with the U.S. economy in autumn 2008, and you’ll probably hear that the buying and selling of options contributed to the meltdown. But what is an option, and, assuming that it was not among the original flora or fauna in the Garden of Eden, where did it come from?

An option is a financial contract in which a buyer purchases the right, but not the obligation, to buy or sell something at an agreed upon time in the future at an agreed upon price. Instead of buying or selling an equity share, foreign currency or commodity outright at its present market price, you buy the option of buying or selling it in the future at a certain stipulated price. As esoteric a financial concept as this may seem, options contracts have existed for centuries.

¹A derivative designates a broader category of financial instruments in which the value of the payout of the contract is derived from another source, such as forwards, futures, options, credit default and other kinds of swaps, and combinations thereof. For our purposes, derivatives and options fall into a similar category of financial contracts that have exploded in recent decades, enabled by the Black-Scholes equation and other factors.

²“Southwest Airlines Flies to $14 Unless Hedging Losses Eat Profits”, Forbes, June 30, 2011.