Nassim Taleb and Espen Haug have
a paper out. Here’s the abstract:
Options traders use a pricing formula which they adapt by fudging and changing
the tails and skewness by varying one parameter, the standard deviation of
a Gaussian. Such formula is popularly called Black-Scholes-Merton owing to
an attributed eponymous discovery (though changing the standard deviation
parameter is in contradiction with it). 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.
Over at BreakingViews (subscription required), Pablo Triana explains
what this means:
The Black-Scholes-Merton (BSM) option pricing model won two of its authors
a Nobel Prize in economics. But a potentially revolutionary paper by Nassim
Taleb and Espen Haug has thrown the whole edifice into question…
BSM may be reduced to what Taleb and Haug deem a “marketing exercise”.
All that BSM did is re-derive an already existing formula by using new and
quite fragile theoretical arguments.
Even more dramatic and watersheddy, Taleb and Haug argue that actual option
prices on the open market may be simply the result of the interaction of supply
and demand, with no formula involved. That goes against BSM, which says demand
forces should play no role in pricing…
Why is all this relevant? There are at least two crucial consequences. First,
the whole role of quantitative finance is thrown into question…
The second implication of Taleb and Haug is that implied volatility, a ubiquitous
element of the markets, ceases to make sense. In fact, it would cease to exist…
Rather than being the “market´s expected future turbulence”
or the “market´s fear gauge”, as conventional wisdom would
hold, implied volatility would have proven itself to be nothing but make-believe.
A nonexistent ghost.
Now I’m not remotely educated enough in such matters to critically assess the
Haug-Taleb paper, or its interpretation by Triana. But I am looking forward
to a spirited debate.
(Via Kedrosky)