Monday, March 03, 2008

Black Scholes Pricing Model - National Business News - Portfolio.com

Black Scholes Pricing Model - National Business News - Portfolio.com:
"The model is based on the assumption that a trader can suck all the risk out of the market by taking a short position and increasing that position as the market falls, thus protecting against losses, no matter how steep. Nearly every employee stock-ownership plan uses Black-Scholes as its guiding principle. A pension-fund manager sitting on billions of U.S. equities and fearful of a crash needn't call a Wall Street broker and buy a put option—an option to sell at a set price, limiting potential losses—on the S&P 500. Managers can create put options for themselves, cheaply, by shorting the S&P as it falls, and thus, in theory, be free of all market risk."
Brett sent me this. It is not ground breaking, but is definitely worth a read.

1 comment:

Rich said...

One of my students handed me that article and its a pretty bad piece. It basically just rehashes the premise of the Nova TV special that was broadcast years ago on Black Scholes and LTCM. The difference now is that this Taleb guy is included. Taleb made a buck in 1987 by guessing in the opposite direction to the rest of the market. Apparently he hasn't been able to repeat since. So since then he has made it his business to trash nobel prize winning economists. He thinks that the Nobel should be revoked here.

What he seems to fail to recognize is that Black Scholes is just a simple model. If you mis-specify the volatility going in, or the vol changes, you'll misprice the security.