26 lines
1.7 KiB
Plaintext
26 lines
1.7 KiB
Plaintext
29
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Chapter 2
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The black-scholes-
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merTon model
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As you can tell from Chapter 1, options are in fact simple financial instru-
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ments that allow investors to split the financial exposure to a stock into upside
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and downside ranges and then allow investors to gain or accept that expo-
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sure with great flexibility. Although the concept of an option is simple, trying
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to figure out what a fair price is for an option’s range of exposure is trickier. The
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first part of this chapter details how options are priced according to the Black-
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Scholes-Merton model (BSM)—the mathematical option pricing model
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mentioned in Chapter 1—and how these prices predict future stock prices.
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Many facets of the BSM have been identified by the market at large
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as incorrect, and you will see in Part III of this book that when the rubber
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of theory meets the road of practice, it is the rubber of theory that gets
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deformed. The second half of this chapter gives a step-by-step refutation
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to the principles underlying the BSM. Intelligent investors should be very,
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very happy that the BSM is such a poor tool for pricing options and pre-
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dicting future stock prices. It is the BSM’s shortcomings and the general
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market’s unwillingness or inability to spot its structural deficiencies that
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allow us the opportunity to increase our wealth.
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Most books that discuss option pricing models require the reader to have
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a high level of mathematical sophistication. I have interviewed candidates with
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master’s degrees in financial engineering who indeed had a very high level
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of mathematical competence and sophistication yet could not translate that
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sophistication into the simple images that you will see over the next few pages. |