<p>
</p>
<p>An unrelated event, is it? Hmmm, financial institutions that over-relied on dodgy models that lost billions of dollars and triggered a government bailout. Sounds pretty related to me. The problem is that nobody seemed to learn from LTCM. They thought they learned, but they obviously didn’t learn. </p>
<p>
</p>
<p>Ha! Well, then, the 2nd (and 3rd and 4th, etc.) things you learn in financial economics are how to do just that! Or, at least, how they think they can do that. </p>
<p>
</p>
<p>The (sad) truth is that economics is not a science. What makes the Schrodinger equation useful is that it has been used to predict experimental results to a very high degree - that the resulting quantum wavefunction does in fact predict the probabilities of locating quantum-scale particles to a highly accurate degree. One can engage in philosophical debates about what exactly that wavefunction really means (i.e. the question of “where” exactly was the particle before I decided to look for it vis-a-vis the Copenhagen interpretation vs. Many Worlds vs. ensemble vs. many minds, etc.), but there is no question that the Schrodinger equation has been continually verified by providing predictions that have been repeatedly experimentally confirmed. Furthermore, Schrodinger follows the key principle of falsifiability. All you would need is find one experimental result that does not conform to the Schrodinger predictions in order to throw the entire theory into question. </p>
<p>But has Black-Scholes done the same? That is to say, has it survived any true experimental tests of its validity? No. In other words, nobody really “knows” whether Black-Scholes is true. It’s certainly not scientific, in the sense that it relies on the scientific method. If we find a case of options pricing that does not conform to Black-Scholes, would that invalidate Black-Scholes? Sadly, it probably would not. In other words, Black-Scholes and other financial modeling equations are really axioms rather than actual scientific equations. The irony is that Black-Scholes is true only in the sense that we as a society believe it to be true, and hence arbitrage away any price discrepancies that do not conform to the equation, but we don’t know whether it’s actually true in any greater sense. Particles would behave according to the principles of quantum mechanics whether we chose to believe in those principles or not. But an options market that does not conform to Black-Scholes would probably just be seen as offering a profitable arbitrage opportunity. In other words, the “problem” would be with the market, not with the theory itself. </p>
<p>Look, the truth is, financial economics is basically just a sub-branch of mathematics leavened with philosophy, neither of which is a science, for neither is inherently falsifiable and neither is concerned with empirical, experimental results.</p>
<p>Hence, I would argue, if anything, you should study economics with a decidedly unscientific mind if you want to do well. To paraphrase Feynman, economists don’t make predictions, they make excuses. </p>
<p>
</p>
<p>Well, your prof didn’t tell you the whole story. Yes, technically speaking, Newton died in debt. However, a few years prior to his death, he had bequethed a quite considerable fortune to his nieces and nephews. It’s actually a rather brilliant strategy: to die in debt because you had already legally bestowed all of your riches to your family, hence leaving your creditors with no way to collect after your death.</p>
<p>When Newton died in 1727, with almost three decades of his cut from the Mint’s prodution in hand, he left an estate — excluding the land inherited from his mother — worth 30,000 pounds. That’s between four and five million pounds in contemporary currency. Newton died rich…</p>
<p>[Friday</a> (Isaac) Newton blogging: Q: How did Newton get rich? (A: He mastered a mundane form of alchemy.) « The Inverse Square Blog](<a href=“http://inversesquare.■■■■■■■■■■■■■/2008/02/01/friday-isaac-newton-blogging-q-how-did-newton-get-rich-a-he-mastered-a-mundane-form-of-alchemy/]Friday”>Friday (Isaac) Newton blogging: Q: How did Newton get rich? (A: He mastered a mundane form of alchemy.) | The Inverse Square Blog)</p>