Another Wall Street worry: A (potentially) flawed risk formula

Is the Black-Scholes formula flawed?

Some now argue that Black Scholes underestimates price jumps and that it's impossible to manufacture an option on a stock market by selling and buying the market itself because the market won't allow it. Even worse, this alternative school argues that regarding extreme events, Black Scholes is not just wrong, it is very wrong.

Some traders have abandoned Black-Scholes in theory, but the market itself hasn't. In fact, the use of Black-Scholes has multiplied with the growth of the derivatives market, which now totals $415 trillion.

Hence, financial institutions may be underestimating the risk of various investment scenarios. Even worse, these institutions may believe they are adequately hedged, when in fact, they are not.

Market Analysis: The article argues that not only does Black-Scholes not price risk accurately, it led to the creation of financial products designed to hedge risk but that don't do that to the degree forecast.

Very likely, at some point in the near future the U.S. Congress will have to take a systematic, professional look at Black-Scholes and other formulas used to calculate risk. More broadly, Congress must also investigate hedge funds, many of which undoubtedly use the Black-Scholes formula, and consider proposals to bring hedge funds and their lateral organizations into the regulated financial system. That's because if the Black-Scholes critique is correct, the financial system contains more risk than hedge funds or other institutions assume, and given hedge funds' largely unregulated status, federal officials have little way to monitor their financial status.