Models in finance are instruments such as a derivative pricing equations or an algorithm for high-speed trading. The options pricing model that Black invented with his colleague Myron Scholes exemplifies a broader problem for economists of finance: that theories or models, to paraphrase Milton Friedman, “are engines not cameras.”One way to read that statement is that the model does not represent the world but makes it. Furthermore, many from behavioral scientists to tech entrepreneurs to political strategists have come to believe that human judgement is flawed, and that this is not a problem, but a frontier for social networks and artificial intelligence. The idea that we are all networked together and make collective decisions within frameworks of self-organizing systems that cannot be perfectly regulated or guided is ubiquitous today and integrated into our smartphone trading apps and social networks. Noise is also, and not coincidentally, the language of mathematical theories of communication. Noise is the result of human subjectivity in systems with too much data to really process. Noise, Black argued, is about a lot of small actions networked together accumulating in greater effects on price and markets than large singular or perhaps even planned events. But Greenspan might have gotten it wrong on one crucial point: irrational exuberance is not the sign of market failure, but market success.įor Black, who was the student of Marvin Minsky and also invented the revolutionary trading instrument the Black-Scholes Options Pricing Model, “irrationality” was not an exception, but the norm the very foundation for contemporary markets. “Irrational exuberance” to quote Federal Researve Board Chairman Alan Greenspan in the late 1990s on the dot.com boom, might be the term to describe it. In retrospect, everyone seems to have perfect clarity about “value” investing, while at the same time, no one does. For the past few years, great fortunes and major funds have collapsed and risen on just such bets. Does anyone, after all, really think a crypto currency named as a joke for a small dog, or an almost bankrupt mall-based game retailer is intrinsically worth anything, much less billions of dollars? Of course they do. In an age of meme driven speculation, NFT’s, and democratized options trading, such a statement might seem common sense. Noise is the very infrastructure for value. Assuming a large number of “small” events networked together as far more powerful than large scale planned events, the vision of the market here is not one of Cartesian mastery or fully informed decision makers. In his famous article “Noise Trading,” Black posited that we trade and profit from misinformation and information overload. In 1986 Fischer Black, one of the founders of contemporary finance, made a rather surprising announcement: bad data, incomplete information, wrong decisions, excess data, and fake news, all make arbitrage-purportedly risk-free investments, such as the profit that can be made when one takes advantage of slight differences between currency exchanges (or the price of the same stack) in two different locations-possible. Noise makes trading in financial markets possible, and thus allows us to observe prices for financial assets… We are forced to act largely in the dark. Noise in the sense of a large number of small events is often a causal factor much more powerful than a small number of large events can be.
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