SOME DRAWBACKS OF BLACK-SCHOLES

To provide one motivation for the development of ARCH models (next handout), we briefly dis-

cuss here some difficulties associated with the Black Scholes formula, which is widely used to calculate

the price of an option. For example, consider a European call option for a stock. This is the right to

buy a specific number of shares of a specific stock on a specific date in the future, at a specific price

(the exercise price, also called the strike price). If all these quantities are fixed, the question becomes:

what is a fair price to charge for the option?

The Black-Scholes formula gives the price of the option, in terms of other quantities, which are

assumed known. These include the exercise price and the current price of the stock. The formula is

derived under the assumption that the time interval between observations is very small, and that the log

prices follow a random walk with normally distributed innovations. The formula is not affected by any

linear drift in the random walk. The model for the stock prices themselves is called geometric Brownian

motion.

A key input to the Black-Scholes formula is σ, the standard deviation of the stock’s continuously

compounded rate of return. (The continuously compounded rate of return is the change in the log price

divided by the length of time elapsed). If the time interval between observations is sufficiently small, σ

is just the standard deviation of the innovations in the random walk, so σ can be viewed as a measure of

the volatility of the stock price. According to the random walk model, σ must remain constant over

time. Its value will not be known, however, so it is usually estimated from the available data.

Several of the assumptions used in the Black-Scholes method may be unrealistic. First, the

geometric Brownian motion model implies that the series of first differences of the log prices must be

uncorrelated. But for the S&P 500 as a whole, observed over several decades, daily from 1 July 1962 to

29 Dec 1995, there are in fact small but statistically significant correlations in the differences of the logs

at short time lags. (See the attached plot). (Of course, the detection of these correlations will require a

large amount of data, as well as the assumption of stationarity, i.e. that the correlations have not

changed over time).

The next question is whether the innovations (say, the returns) are normally distributed. The

answer to this is almost surely NO! Experience has shown that returns are leptokurtic , i.e., have much

more of a tendency to exhibit outliers than would be the case if they were normally distributed. An

example is provided by the returns on the S&P 500 series. The attached Minitab Descriptive Statistics

output shows a sample kurtosis of 43.69. By contrast, the true kurtosis of any normal random variable is

just 3. The p -value on the Anderson-Darling Normality Test is 0.000, indicating that we can strongly

reject the null hypothesis that the returns are normal. The graphical part of the output shows a histo-

gram of the returns, with a superimposed normal curve matching the mean and variance observed in the

data. The fit is not good, in that the histogram has much more mass in the center than the normal, and

there is a large amount of data located several standard deviations from the mean, i.e., far in the tails of

the normal distribution. This can be seen with the help of the boxplot of the returns located below the

histogram. So there is overwhelming evidence that the returns are not normal, but instead have a lep-

tokurtic (i.e., long-tailed) distribution.

Finally, there is the question of constancy of the variance of the innovations. In practice, it is

often found that for financial time series, after taking logs (if needed) and first differences, the level of

volatility (i.e., fluctuation) seems to change with time. Often, periods of high volatility follow immedi-

ately after a large change (often downward) in the level of the original series. It may take quite some

time for this heightened volatility to subside. For example, the plot of differences of the logs of the S&P

500 shows very long periods of high volatility interspersed with periods of relative calm. This type of

pattern is often referred to as volatility clustering. A way to measure this clustering is to look at the

autocorrelations of the SQUARES of the differences of the logs (or of the squared returns). If there is

volatility clustering, these autocorrelations should be significant for many lags, so that a shock to the

volatility persists for many periods into the future. This is the case for the S&P 500.

Similar findings of leptokurtosis and volatility clustering have been obtained for the differences of

the logs of individual stock prices, exchange rates, and interest rates.

Clearly, if any of its underlying assumptions is violated, the Black-Scholes formula may be

invalid, so the computed options prices may not be fair. In particular, an estimate of variance based on
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historical data may severely detract from the fairness of the computed options price if the stock has just

entered a highly volatile phase. Leptokurtosis in the innovations can produce further pricing biases. Hull,

in his book "Options, Futures, and Other Derivatives", 3’rd Edition, pp. 492-495 (attached) discusses

how long tails in the original stock price distribution relative to a log-normal distribution can cause

Black-Scholes to systematically under-price or over-price an option.

In spite of these problems, and because of its simplicity, Black-Scholes is still very widely used,

but with adjustments to account for the inadequacy of the model on which it is based. To some extent,

the inadequacies can be gauged from from looking at "implied volatility", i.e., the value of σ inferred

from using the Black-Scholes formula in reverse, based on the observed option prices. If the model

underlying Black-Scholes (i.e., that stock prices are a geometric Brownian motion) actually held, then

implied volatility should be constant with respect to both strike price ("moneyness") and maturity. In

fact, implied volatility changes with strike price (giving a "volatility smile"), and with maturity (giving a

"volatility term structure"). These are discussed in Hull, pp. 502-504 (attached).

Although Black-Scholes will undoubtedly continue to be used for many years, it is very clear that

the model underlying its use is strongly at odds with the observed data. In the following handouts, we

will consider more appropriate models for innovations of financial time series (ARCH-GARCH models),

and discuss ways of pricing options under such a model.