Getting the Right Option Price with the Wrong Model

15 Pages Posted: 13 Oct 2001

See all articles by Jeremy Berkowitz

Jeremy Berkowitz

University of Houston - Department of Finance

Date Written: October 8, 2001

Abstract

Despite recent advances in modeling option prices, traders and other practitioners have resisted using more complex theoretical formulas. The most widely used valuation procedure among practitioners is a variant of the Black-Scholes framework with ad hoc adjustments and frequent updating. Why do traders continue to use this practitioner Black-Scholes (PBS) model to price and hedge options when the model's assumptions about the underlying asset price are clearly wrong? In this paper, we provide a theoretical justification for the practice. We show that the PBS model can be cast as a functional approximation to the true but unknown option pricing formula. When fit to a large number of observed prices, the implied volatility surface will exactly price the full cross-section. If the implied volatility surface is re-calibrated sufficiently frequently, then out of sample forecasts of option prices become arbitrarily accurate.

Suggested Citation

Berkowitz, Jeremy, Getting the Right Option Price with the Wrong Model (October 8, 2001). Available at SSRN: https://ssrn.com/abstract=286816 or http://dx.doi.org/10.2139/ssrn.286816

Jeremy Berkowitz (Contact Author)

University of Houston - Department of Finance ( email )

Houston, TX 77204
United States

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