The danger of Black Scholes

An article by Michael Lewis in Portfolio magazine points out the flaws in the Black Scholes model. One of which is the higher occurence of extreme market moves than previously assumed (on the same topic see also Nassim Taleb in The Black Swan). Another problem is the difficulty of taking a short position - and dynamically managing that position - when a market is crashing.

This is not just of academic interest, as according to Lewis-

At the end of 2006, according to the Bank for International Settlements, there were $415 trillion in derivatives—that is, $415 trillion in securities for which there is no completely satisfactory pricing model. Added to this are trillions more in exchange-traded options, employee stock options, mortgage bonds, and God knows what else—most of which, presumably, are still priced using some version of Black-Scholes.

Lewis concludes-

Financial panics have become almost commonplace; events that are meant to occur once in a millennium now seem to occur every few years. Could this be because the financial system was built on an idea that badly underestimates the risk of catastrophes—and so conspires with human nature to create them?