Wall Street Questions 35 Correctly Answered Questions Latest Update

What caused options prices to converge towards the predictions of the Black-Scholes-Merton model, at least until 1987? {Ans: When the Black-Scholes-Merton model first started being used in the 1970s, there was a big gap between theoretical and real prices. But the model did play an important legitimating role for early options exchanges. Black-Scholes-Merton ultimately had simplicity on its side: the model has only one parameter (volatility) that traders had to reason about, and it was something they understood intuitively from their own floor experience. The cognitive simplicity of B-S-M, its public availability, and the idea of using paper price sheets made it possible for the model to gain a foothold on the trading floor, despite early skepticism. Volatility was the key parameter in the Black-Scholes-Merton model: options on more volatile stocks were worth more, so options are really bets on how volatility is going to change. Gradually, people stopped thinking about trading options and instead started thinking of themselves as trading volatility. Furthermore, with so many people using the BSM to depict markets, despite its many flaws was able to predict pricing do to its high exposure. Markets are social constructs, and if we think of them differently, they