It´s The Smile, Stupid!

In my humble opinion, the most insightful insight of Taleb&Haug´s analysis of the originality-validity-popularity of Black-Scholes-Merton is the following: when you fudge BSM through the vol parameter, the model you are using no longer is BSM. What had previously been described (including yours truly) as BSM´s number one advantage, becomes its exterminator. It was there for all of us to see, but sometimes the obvious refuses to be found.

So the vol smile, rather than representing BSM´s number one asset (the flexibility to allow traders to obtain desirable prices) represents in fact its demise.

Through two conduits: 1) if the smile is the result of vol fudging, then the model is no BSM, 2) if the smile is the result of supply-demand then prices are supply-demand based and no model, including BSM, is used

Smiling at BSM? More like frowning!

ptriana@profesor.ie.edu