Volatility and Correlation
The Perfect Hedger and the Fox
Chapter One
Theory and Practice of Option
Modelling
1.1 The Role of Models in Derivatives Pricing
1.1.1 What Are Models For?
The idea that the price of a financial instrument might be arrived at using a complex
mathematical formula is relatively new, and can be traced back to the Black-and-Scholes
(1973) formula. Of course, formulae were used before then for pricing purposes, for
instance in order to convert the price of a bond into its gross redemption yield. However,
these early (pre Black-and-Scholes) formulae by and large provided a very transparent
transformation from one set of variables to another, and did not carry along a heavy
baggage of model assumptions. The Black-and-Scholes formula changed all that, and
we now live in a world where it is accepted that the value of certain illiquid derivative
securities can be arrived at on the basis of a model (the acceptance of this is the basis of
the practice of marking-to-model).
The models that developed from the family tree that has Black-and-Scholes at its
roots shared the common assumptions that the estimation of the drift (growth rate, trend)
component of the dynamics of t ... read full excerpt from Volatility and Correlation: The Perfect Hedger and the Fox ebook
