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Chapter 12: Black-Scholes

J

jensen

Member
The first part of this chapter shows how unrealistic the underlying assumptions are, and yet the model is still widely used as results are believed to be close approximations to reality.

Is there any evidence the model is close to reality, or is there any part of the model which does reflect derivative prices in reality?
 
Black-Scholes used in real life?

Hi Jensen,

My understanding is that, despite the criticisms of the assumptions, the Black-Scholes model is used in real life for a wide range of topics in the financial world and you will find numerous books on the subject just by surfing the net. I have just found "Basic Black-Scholes: Option Pricing and Trading" amongst others on Amazon

A model should ultimately be judged on whether it produces accurate results, even, absurdly, if it is based on preposterous assumptions! Of course, there is always going to be a correlation between the accuracy of a model and the realism of its assumptions. I think the main focus of the Black-Scholes model is the constant volatility assumption - this is where investors have had trouble with it in real life.

I believe there is a diagram showing how real-life implied volatilities are not a linear function of the strike price as Black-Scholes suggests they should be. Subject ST6 goes into this a bit deeper, you might like to post your query there?

Good luck!
John
 
Thanks John

Was just curious about the topic and I'll sure pay more attention to the linear volatility assumption now :)
 
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