One answer presumably lies in the fact that Black-Scholes is used to price employee stock options, which constitute a fair portion of executive compensation packages. If company performance is based on stock price, which is a short-term measure, then perhaps the reason for using Black-Scholes becomes easier to understand?
Jayson Funke Graduate School of Geography Clark University 950 Main Street Worcester, MA 01610 -----Original Message----- From: PEN-L list [mailto:[EMAIL PROTECTED] On Behalf Of raghu Sent: Thursday, December 28, 2006 9:45 PM To: [email protected] Subject: Re: [PEN-L] Query on Financial Instruments On 12/28/06, Michael Perelman <[EMAIL PROTECTED]> wrote: > MacKenzie, Donald A. 2006. An Engine, Not a Camera (Cambridge: MIT > Press). > > He tells this story very well. But then he explains how the players > discovered its limits. Speaking of Black-Scholes limitations, Fischer Black was said to have been astonished at the extensive use of their formula on Wall Street, because he regarded the continuous time and log-normal price assumptions as unrealistic. There is also significant evidence that the Black-Scholes price became a self-fulfilling prophesy, and later when the binomial pricing was introduced, THAT formula quickly became the new self-fulfilling prophesy. See for e.g. "Options markets, self-fulfilling prophecies, and implied volatilities" Cherian, Jarrow et al., 1998 The big question is why was Wall St so eager to adopt unproven formulas based on questionable assumptions. Why were they not scared of losing money? How indeed did they avoid losing money? -raghu.
