The Black Scholes model's assumptions for option pricing and risk management may not hold in the real world due to frictions like trading costs and non-uniform prices.
The real-world options market exhibits time variation in implied volatilities, resulting in skewed term structures that deviate from the Black Scholes model's assumption of constant implied volatility.
Deep dives
The Macromines 2023 Charitable Investment Symposium
The podcast episode begins with the host, Dean Krenut, discussing the Macromines 2023 Charitable Investment Symposium. This event brought together over 225 attendees from various financial communities to collaborate and support three charitable beneficiaries. The event successfully raised $430,000, contributing to a total of $1.4 million raised over three years to support student education.
The Assumptions and Breakdown of the Black Scholes Model
The podcast delves into the Black Scholes model and its assumptions for option pricing and risk management. While the model assumes continuous trading, zero transaction costs, uniform tax rates, and risk-free borrowing and lending, the real world experiences frictions and variations. These frictions include actual trading costs, non-uniform prices, and the absence of risk-free lending. The podcast highlights the importance of understanding these assumptions and their consequences in implementing the Black Scholes model.
Term Structure and Implied Volatility
The podcast explores the concept of term structure and implied volatility in options pricing. While the Black Scholes model assumes a constant implied volatility across all strike prices and expiration dates, the real-world options market exhibits time variation in implied volatilities. The podcast discusses examples such as corporate earnings dates, macro catalysts, and episodes of extreme volatility that result in skewed term structures and variations in implied volatilities.
Option Strike Skew and Market Realities
The podcast highlights the discrepancy between the Black Scholes model's assumption of normally distributed stock returns and the empirical reality of market behavior. It explores the strike skew, whereby implied volatility for out-of-the-money puts is higher than for out-of-the-money calls. This skew reflects the market's recognition of fat tails and the occurrence of large down and up moves in stock prices. The podcast provides examples of companies experiencing significant stock price fluctuations during earnings announcements and explains how these market realities affect the cost and implementation of option trades.
As we cue up some new guests for the Alpha Exchange, some reflections from your host on the Black Scholes model and its 50th anniversary. No model is perfect and traders must grapple with real world frictions not entertained by the model. I discuss how option market participants make adjustments and why. Hope you enjoy!
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