Canadian Investment Review

Black Swan Bites Black-Scholes

Written by Caroline Cakebread on Thursday, February 4th, 2010 at 1:39 pm

black swan_sizeI was browsing the Financial Economics Network the other day and noticed that one of the most downloaded papers on the site is Nassim Taleb and Espen Haug’s paper, “Why We Have Never Used the Black-Scholes-Merton Option Pricing Model.” I’ve attached the most up-to-date version here. Some of you have probably heard this argument before but it’s worth repeating. We’d be interested in knowing your thoughts as plan sponsors – see the comment box below. Here’s a summary of what the authors discuss in their paper. Here they claim to have historical evidence that:

1) Black, Scholes and Merton did not invent any formula, just found an argument to make a well known (and used) formula compatible with the economics establishment, by removing the “risk” parameter through “dynamic hedging”,

2) Option traders use (and evidently have used since 1902) heuristics and tricks more compatible with the previous versions of the formula of Louis Bachelier and Edward O. Thorp (that allow a broad choice of probability distributions) and removed the risk parameter by using put-call parity.

3) Option traders did not use formulas after 1973 but continued their bottom-up heuristics. The Bachelier-Thorp approach is more robust (among other things) to the high impact rare event.

Access the paper here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1012075

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