No one ever bet enough on a winning horse
---Richard Sasuly.
In these two lectures, we'll define derivatives, talk about some age old futures markets: the case of the philosopher's olive grove, and derive and manipulate the Black Scholes model of option pricing. We'll also spend some time explaining just how flawed a model of option pricing this is.
Derivatives are risky assets priced on the value of underlying assets. Their values become the same at the maturity of the contract. Derivatives have been around for a long time, but the modern versions were only really traded since the early 1970's. There are many factors influencing the price of a derivative, and several formulae which help us understand what price a derivative should be priced at. One of these is the Black-Scholes model.
However, there is controversy over the correct pricing formula. Skeptics of the BS model like Nassim Taleb and others point out the flaws in the pricing formulae, and this debate matters because when options are mis-priced badly, people suffer needlessly.
I'll show you an example of a pricing decision in the market, a Mathematica simulation of the model, and show you some real world data to support the pricing models. It should be noted that every trader in the financial system actually uses the BS model as a benchmark rather than a guiding principle, so it makes a lot of sense to use the same terminology throughout. It's important to get the pricing of these things right. What happens when derivatives are mispriced? Bear Stearns happens.
Below you'll find slides, the handout, and links to the programs I'll use in class, as well as some readings.
Slides
