Black Scholes Replacement?

T

toben

My Finance Prof. said the investment banks were no longer modeling options through Black Scholes due to the "fat tails" problem.

How do they model them now? What is the replacement formula?

Anyone have this in a spreadsheet I can use?

Anyone know of a good place to learn about more advanced modeling techniques?

I did some modeling in excel in some classes but only for simplistic scenarios.
 
Quote from toben:

My Finance Prof. said the investment banks were no longer modeling options through Black Scholes due to the "fat tails" problem.

How do they model them now? What is the replacement formula?

Anyone have this in a spreadsheet I can use?

Anyone know of a good place to learn about more advanced modeling techniques?

I did some modeling in excel in some classes but only for simplistic scenarios.
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Your finance professor never told you about volatility smile ?
 
Don't get caught in model-fallacy. Look for stat-arb, replication and relative value opportunities. Modeling skew is pointless.
 
Quote from toben:

So can anyone help me out on the formula modeling part?
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If you don't want to use B&S formula and adapt the vol for OTM options, juste simulate your returns under market neutral prob with what you believe the distribution of returns is, compute your payoff, and discount it.

As simple as that.
 
Quote from toben:

My Finance Prof. said the investment banks were no longer modeling options through Black Scholes due to the "fat tails" problem.
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This is surprising. People in the bank I'm working for don't seem to be aware of this lol

ScienceTrader is correct, the volatility smile takes care of the fat tail problem your prof highlight. Tell him to think about this and revert.
 
Quote from science_trader:

If you don't want to use B&S formula and adapt the vol for OTM options, juste simulate your returns under market neutral prob with what you believe the distribution of returns is, compute your payoff, and discount it.

As simple as that.
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Yes but I'm afraid if he does that this chap is gonna find himself a little bit off vs the market isn't he ? His mark-to-market PnL is going to look like very funny.
 
Quote from jrkob:

This is surprising. People in the bank I'm working for don't seem to be aware of this lol

ScienceTrader is correct, the volatility smile takes care of the fat tail problem your prof highlight. Tell him to think about this and revert.
More...


Smile drives the skew... how does it take care of the problem?
 
Quote from jrkob:

Yes but I'm afraid if he does that this chap is gonna find himself a little bit off vs the market isn't he ? His mark-to-market PnL is going to look like very funny.
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:D
 
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