Tweaking Black-Scholes

30 Pages Posted: 22 Jan 2009 Last revised: 4 Mar 2009

See all articles by Do-Sub Jung

Do-Sub Jung

affiliation not provided to SSRN

Charles J. Corrado

Deakin University - School of Accounting, Economics & Finance

Date Written: March 2009

Abstract

Option professionals routinely tweak the Black-Scholes option pricing model using a volatility smile. Using algebraic analysis and Monte Carlo simulation experiments, we compare the hedging performance of the tweaked Black-Scholes option pricing model with a stochastic volatility model in a stochastic volatility setting. We find that the tweaked Black-Scholes model almost perfectly mimics the stochastic volatility model representing the true stochastic process. This suggests why volatility smiles are widely used by options professionals to calibrate option trading and hedging strategies. These results also have implications for empirical tests of option pricing models.

Keywords: options, hedging, Black-Scholes

JEL Classification: G12, G13

Suggested Citation

Jung, Do-Sub and Corrado, Charles J., Tweaking Black-Scholes (March 2009). Available at SSRN: https://ssrn.com/abstract=1330248 or http://dx.doi.org/10.2139/ssrn.1330248

Do-Sub Jung

affiliation not provided to SSRN

Charles J. Corrado (Contact Author)

Deakin University - School of Accounting, Economics & Finance ( email )

221 Burwood Highway
Burwood, Victoria 3215
Australia
61492446214 (Phone)

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