Thursday, September 13, 2007

Taleb takes on Black, Scholes, Merton

WOW. This one is hard hitting for any paper, let alone an academic paper.

And on top of that it is co-authored by Espen Haug and Nissam Taleb (yep same one).

The paper itself says "do not quote" so I won't. It also says do not disseminate but the authors (put it online, so I think that one is just for show....lol).

But the abstract is fair game, so from the abstract:
"However we 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) 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. The Bachelier-Thorp approach is more robust (among other things) to the high impact rare event. It is time to stop calling the formula by the wrong name."
Talk about a major claim. So for the record, yes the Black-Scholes Option Pricing model (BSOPM) relies too heavily on the normal distribution. That has been known for seemingly ever. I remember my professors saying it back in the stone age. But the many parts will definitely get your attention (Especially if you have read Taleb rail against the normal distribution in his Black Swan book.)

It is also well known that much of the BSOPM did grow out of Bachelier's work (see for instance the Nova presentation Trillion Dollar Bet.) I do not know the extent of option pricing literature (and use?) prior to the BSOPM but it is worth a look or two.

Cite: Haug, Espen Gaarder and Taleb, Nassim Nicholas, "Why We Have Never Used the Black-Scholes-Merton Option Pricing Formula" . Available at SSRN: http://ssrn.com/abstract=1012075


Thanks to Barry over at the Financial Page (which is a great blog btw) for mentioning this one!

1 comment:

Adam Babcock said...

After thinking about for it several moments I question how ground breaking this is. It seems that it is common knowledge that part of the formula was "borrowed" from fluid dynamics, and you yourself point out that the model heavily relies on the assumption of a normal distribution, which we all know is far from true. I think the most important thing to take out of this is for the time being the Black-Scholes (or whatever you want to call it) is the best model that we have presently