Tuesday, February 26, 2008

In defence of Black Scholes.

The famous Emanuel Derman is out with an excellent piece in defense of Black Scholes

So, what can you do? Black-Scholes is a zeroth order approximation with (perhaps) a series of first- and second- and higher-order corrections. I say "perhaps" because claiming there are higher order corrections implies that someone knows the correct answer, and that's not true. You have to think of Black-Scholes as being the right answer is a Platonic world that doesn't match the one we live in.

If you're a trader or a quant, you ought to think of Black-Scholes as a way of thinking about things, an ideal formula that doesn't hold in the real world, and now it's up to you to decide how to correct for its omissions.

It's like Newton's first law.. it doesn't really hold true in the real world. But that doesn't mean it doesn't serve a purpose. The important thing is to understand the underlying limitations, and adjust accordingly.