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Flaws With Black Scholes And Exotic Greeks

9364 words - 38 pages

Flaws with Black Scholes & Exotic Greeks

Treasury Perspectives

Flaws with Black Scholes
& Exotic Greeks


Flaws with Black Scholes & Exotic Greeks


Flaws with Black Scholes & Exotic Greeks

Dear Readers:It’s been a difficult and volatile year for companies across the Globe. We have seen numerous
risk management policies failures. To name a few... UBS, JPM Morgan, Libor manipulations by
European, US and Japanese banks and prominent accounting scandals like Lehman…
As rightly said by Albert Einstein “We can't solve problems by using the same kind
of thinking we used when we created them.” and when you can't solve the
problem, then manage it and don’t be dependent ...view middle of the document...

Thanks You,
Rahul Magan
Author, Flaws with Black Scholes & Exotic Derivatives

Twitter: - Rahulmagan8
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Flaws with Black Scholes & Exotic Greeks

Flaws with Black Scholes Model (BSM) & Exotic Greeks
Rahul Magan
Sydney, Australia
In 1973, Fisher Black, Myron Scholes and separately Robert Merton derived the Black-ScholesMerton (BSM) model, which was rewarded the Nobel Prize in 1997. Despite its limitations, the
model has survived until today as the dominant pricing model for standard and exotic
European style options.
The model owes its success to its simplicity, high intuition and versatility. In 1997, the
importance of their model was recognized worldwide when Myron Scholes and Robert Merton
received the Nobel Prize for Economics. Unfortunately, Fisher Black died in 1995, or he would
have also received the award [Hull, 2000]. The Black-Scholes model displayed the importance
that mathematics plays in the field of finance. It also led to the growth and success of the new
field of mathematical finance or financial engineering.
This paper is all about flaws with Black Scholes and subsequent linkages with Exotic Greeks.
Directly Black Scholes is linked with six plain vanilla options Greeks and numerous exotics
linked with each of these plain vanilla Greeks.
The paper is trying to establish relationship between plain vanilla and their linked exotics
besides highlighting various thoughts on flaws with Black Scholes. As per author biggest flaw
with Black Scholes is assumption of constant implied volatility & non applicability of
principle of Skewness which is not true today due to huge monetization programs running by
almost all central banks across the world. Such monetization programs would give rise to
implied volatility and swan shocks and continue to stay for longer periods of time unless
balance sheet deleveraging starts which do have its own positive and negative repercussions.
Paper also takes various references of plain vanilla Greeks, exotic Greeks, respective
formulations and last but not the least effective hedging strategies. At respective point’s paper
using various references pertaining to statistical data distributions like Normal Distribution,
Poisson distribution, Weibull Distribution and none the less Extreme value Theory (EVT)
which in turn linked with swan events data shocks. Additional references are also taken to
establish link between FX volatility w.r.t various markets parameters.
Key words: Black Scholes, Options derivatives, Exotic derivatives, Extreme Value Theory and
Statistical distributions.


Flaws with Black Scholes & Exotic Greeks

Table of Contents
Part 1:Central banks monetization programs & Volatility in FX markets
(Topology of economic shocks & Mark to Market)

Page No 7

Part 1[A]: Option Structure and M2M hierarchy – US GaaP (FAS 157)
(Levels in M2M hierarchy)

Page No 10


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