Economic theory and markets: Do birds read flying manuals?

July 8, 2008

Nassim Taleb pointed me to a note on his web site. Taleb says there, among other things, that: when writing history, we project our mental biases in a way to produce agency and increase the role of theory. The idea that academics, in general, are more theory-oriented than explanation-oriented is not new. Indeed, there is a wide spectrum of critical approaches towards theory, from, for example, Paul Fayeraband’s epistemological anarchism to evidence-based medicine.

However, Nassim’s approach becomes the most interesting when he refers to the area he knows best: option pricing. In a talk at the LSE earlier this year (at the Accounting department) Nassim claimed not only that the history of the Black-Scholes formula [shows] that mathematics is often there to “lecture birds how to fly”, but, more provocatively, that options’ traders hardly ever use the Black-Scholes-Merton model and that, in fact, the put-call parity is enough to trade options. Nassim’s claim is coming from his extensive experience as an options trader and I am sure that his observations are authentic and valid. The important question about BSM model, however, is no longer whether or not individual traders use it or not, because when entire price quotation systems are based on BSM, individual traders matter very little in this respect. The question then becomes: to what extent is BSM theory entrenched into financial market systems? The answer to this is fairly obvious: it is profoundly embedded into today’s markets.

Now, let us go back to Nassim’s claim that science in general, and economics in particular, are too theory-oriented. I agree with this claim whole-heartedly, and I think the BSM model case is a very good example for this tendency. However, the arenas where such theory-biases unfold and become effective are not the pages of economics journals (let alone those of philosophy of science), but trading floors, trading rooms and increasingly, trading and risk management algorithms. That is, economic theory is frequently inaccurate (BSM, for example), but is very affective. In other words, in markets, birds (and more so, bird growers) do read flying manuals.

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