Has Nassim Taleb Killed Black-Scholes?

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)

Add Your Comment

Report Abuse

Archive

Categories

Links