Can you believe we are at the midpoint of the year 2021? Today’s blog is on the accuracy of Black-Scholes (“B-S”) option pricing model. As we know, the B-S model is used to value option premiums. However, both practitioners and academics understand that this model is not very accurate. There have been many studies suggesting the previous statement. Just recently, a new academic paper by Drs. Redroban and Cifuentes (1) suggested that not only has the model been inaccurate under certain criteria, but this inaccuracy has been exacerbated during periods of financial crises. For instance, the B-S model have shown to be inaccurate for out of the money options and for those options that have decreasing maturities. And in all practicality, most users of the B-S model people actually use the formula only to estimate volatilities, and not prices. This paper addressed the two most recent financial disasters, the subprime crisis in October 2008 and the onset of the Covid- 19 pandemic in March 2020. The author’s conclusion was when financial crises take place, the model’s accuracy deteriorates. In fact, in many cases the mispricing errors exceeded 100%. The bottom line for valuators is that one should analyze results without taking blind acceptance to any model’s conclusion. Until next time……….
(1) Redroban, S., & Cifuentes, A. (2021). On the performance of the Black and Scholes options pricing formulas during the subprime and Covid-19 crises. J Corp Account Finance, 1–11. https://doi.org/10.1002/jcaf.22504.