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"A Calculus of Risk," by Gary Stix. Scientific American, May 1998.
As worldwide financial markets become more interconnected and complex, new investment products have emerged that can provide insurance against risk, like a drop in the yen or in the thermometer. The act of pricing uncertainty, in the form of derivatives and options, is the essence of financial engineering, an emerging field that is bringing mathematicians, physicists, and computer scientists to Wall Street.
Academics such as Louis Bachelier and Albert Einstein contributed to the theory of finance early in this century, but it did not catch fire with investors until the early 1970s, when the Black-Scholes equations turned the difficult problem of options-pricing into an operation that can be performed on a pocket calculator. However, behind Black- Scholes is stochastic calculus, so enter the Wall Street "rocket scientists" who use this complicated math to develop models that build upon Black-Scholes. Hundreds of mathematical models are currently in use to optimize options-pricing strategy.
No mathematical model can capture the multitude of ever-changing economic factors that perturb world markets. Modeling problems have led to billions of dollars in derivatives losses, and some economists wonder if these models can match the skill and intuition of traders. Emanuel Derman of Golman Sachs, a proponent of modeling, counters with the philosophy that we should "let 1000 models bloom"--the more models we investigate, the better we will bridge the gap between models and the real world.
Despite the concerns of some, financial engineering has flourished on Wall Street, and its influence is spreading. Derman speculates that the Black-Scholes model could be used to organize the financial lives of people in general, in an attempt to hedge whatever risks we may encounter. --- Ben Stein
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