9364 words - 38 pages

Flaws with Black Scholes & Exotic Greeks

Treasury Perspectives

Flaws with Black Scholes

& Exotic Greeks

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Flaws with Black Scholes & Exotic Greeks

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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

LinkedIn- Rahulmagan8@gmail.com

Twitter: - Rahulmagan8

Face book: - Rahulmagan8@gmail.com

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Flaws with Black Scholes & Exotic Greeks

Flaws with Black Scholes Model (BSM) & Exotic Greeks

Rahul Magan

Sydney, Australia

ABSTRACT

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.

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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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