Black-Scholes: Is it simply wrong?

The Black-Scholes pricing model has already been battered by corporations that state the model does not properly reflect the pricing of employee stock options. The gripes of many technology companies include the realities that these employee options are not liquid, have long vesting periods, are lost when an employee leaves the firm, and other factors making the value derived by Black-Scholes absolutely inaccurate. This naturally leads to further imprecision and financial engineering in corporate filings – which does not benefit shareholders.

Now Black-Scholes is under attack from another front – the mainstream financial community. Most traders have ignored the Black-Scholes model for years; finding it next to useless in a fast-paced financial marketplace. However the model is still ingrained in the minds of pension administrators, hedge funds manager, and other institutional executives. There is growing evidence that the model is simply wrong, the most significant problem being that Black-Scholes was never designed for any type of extreme market situation.

Is it time to retract the Nobel Prize awarded to Myron Scholes and Robert Merton for their work in creating the model? Nassim Nicholas Taleb, the author of The Black Swan and Fooled by Randomness appears to believe so. Most of Wall Street is not ready to take this extreme leap however. Many are simply hoping for an updated model that can properly reflect risk.

The current Black-Scholes model views that a multi-sigma event will only occur once every million years, in reality market extremes are much more common. With events that can easily wipe out most risk models occurring regularly within eighteen year periods it is clear that Black-Scholes and other models are broken.

The recent sub-prime crisis should serve as an example to the financial community why proper modeling is needed; rather than greed-driven models focused on putting the largest profits into the pockets of Wall Street firms in the shortest possible time period. While a homeowner who lost their home may not understand the modeling of a credit crisis, Wall Street financial engineers should have an understanding of the obvious risks in their products before billions of dollars are taken as losses.

The panic of October, 1987 should have called the relevance of Black-Scholes into question. A model does not work when investors attempt to sell and nobody will buy. When liquidity is lost, most currently utilized models are worthless. Still the Wall Street community clung to the Black-Scholes model.

Most alarming, if Black-Scholes does not properly model options then trillions of dollars' worth of securities have been priced over the past years without regard to the possibility of multi-sigma events in the markets.

More press is regularly appearing in mainstream financial journals questioning the Black-Scholes model; the detractors will no longer be mute. This trickle is likely to become a roar as Wall Street firms continue to take losses over the coming year which reflects their inability to correctly model risk. At some point, Black-Scholes will be relegated to the financial bit-bucket of the modeling past… only leaving the question if will it occur soon enough to avoid additional pain.

Inside Wall Street’s Black Hole