From Black Sholes to Black Holes: Paradigm Shift-Drift-Rift

As every MBA knows or should know, there are perhaps four bedrock analytical tools of modern finance: i) Net Present Value (NPV); ii) Internal Rate of Return (IRR); iii) Black Sholes Option Pricing Model (Black-Sholes); and, iv) the Capital Asset Pricing Model (CAPM). As global interest rates, risk-free and risk-adjusted, have approached zero globally, the problem of the zero lower bound has created a vexing challenge. As more and more anomalies in the financial markets become evident, the conditions precedent for a classic Kuhnian paradigm shift are upon us. Like the center, the anomalies cannot hold.

As Thomas Kuhn pronounced in his seminal work, The Structure of Scientific Revolutions, within a given scientific field or domain, as anomalies, or deviations from the expected, are observed that are not predicted or explained by the existing paradigm a crisis begins to develop. When there is an emergent theory or model that can better explain or mitigate the anomalies this new and improved theory begins to resolve the crisis and there is a paradigm– new descriptive model– replaces the incumbent. However, a paradigm shift can only take place when a better theory is emergent. This begs the question when a plethora of anomalies present themselves but no better or alternate theory is in sight let alone on the distant horizon? We would posit that this paramount conditions precedent fails to present itself one of two descriptors will occur: i) a paradigm drift or ii) a paradigm rift.

America’s “Exorbitant Privilege”