Always Check Everything
It now seems a bit odd that so many people had for so many years blindly accepted that BS was so widely popular and used in the real world. Why didn´t we stop and ask, really? how do I know? how do you know? have you asked all option traders in the world? well, no, but it says so in the textbook...
It´s unbelievable how suckers we are for perceptions. Everyone. Journalists, academics. students, financiers, analysts. Always triple-check! And if in doubt, doubt!
Another example is the VIX. How many people who talk about the VIX have actually analyzed where the VIX formula comes from and what it means? How many have browsed through Derman´s paper at GS on variance swaps?
I plead guilty myself to falling for perception-fashion. I have written a couple of VIX articles that were based on the notion that the options underlying the replicating portfolio for the log contract were priced using BS and thus one could see the VIX as somehow representative of implied volatility (of the vol smile). I should have made a disclaimer. I absolutely remember myself thinking these prices must come from BS and thus implied vol is real, what the heck surely they must come from BS? From where else could they come? I neglected the possibility that supply and demand may have something to say, or assumed that such forces would be ironed out by traders as yet another ingredient of implied vol into the model.
But the CBOE itself calls the VIX an implied vol indicator! No, it´s not, not exactly. It used to be (when it actually came from BS). Under the new VIX variance and the prices of options are linked "by accident", the result of the replicating strategy, but that does not mean that those prices include precise views on implied vol. The VIX would change when prices change, but this is not the same as being implied. Those (model-independent) prices may contain no vol component at all.
ptriana@profesor.ie.edu
