Risk Management: Foundations for a Changing Financial World

CHAPTER 8

A SIMPLE THEORY OF THE FINANCIAL CRISIS; OR, WHY FISCHER BLACK STILL MATTERS^h

Tyler Cowen

The key question about the current financial crisis is how so many investors could have mispriced risk in the same way and at the same time. This article looks at the work of Fischer Black for insight into this problem. In particular, Black considered why the “law of large numbers” does not always apply to expectations in a market setting. Black’s hypothesis that a financial crisis can arise from extreme bad luck is more plausible than is usually realized. In this view, such factors as the real estate market are of secondary importance for understanding the economic crisis, and the financial side of the crisis may have roots in the real economy as a whole.

Nouriel Roubini (“Dr. Doom”) and the late Hyman Minsky are often heralded as the economic prophets of the current financial crisis. But there are also connections between recent events and the work of Fischer Black (1938-1995). Best known for his seminal work in option-pricing theory, Black also wrote extensively on monetary economics and business cycles.

An enigmatic thinker, Black sometimes wrote in epigrams or brief sentences and did not present his macroeconomic views in terms of a formal model. For that reason, interpreting Black is not always easy. Nonetheless, Black’s writings offer ideas for explaining the current crisis, most notably the idea that a general risk-return trade-off governs business cycles. Black also stressed ...