Valuation and Its Discontents Derivatives 2007 Emanuel Derman Prisma Capital Partners LP & Columbia University Whats the Point of a Financial Model? In physics you predict the future. In finance, you interpolate, extrapolate in the present.
2 Right vs. True? Right is consistent. True is true. 3 Accuracy? Ross: Options pricing is the most successful theory,
not only in finance, but in all of economics. Yes, but how accurate it is? 4 The Volatility Smile S&P Smile QuickTime and a TIFF (LZW) decompressor
are needed to see this picture. BS Smile QuickTime and a TIFF (LZW) decompressor are needed to see this picture. 5
The Volatility Smile S&P Smile QuickTime and a TIFF (LZW) decompressor are needed to see this picture. BS Smile QuickTime and a
TIFF (LZW) decompressor are needed to see this picture. Vulgar models are probably the most practical. 6 The Derivatives Paradigm This is how options theory works: * pick a plausible stochastic process with parameters; * calculate the value of liquid securities whose prices you know;
* calibrate the parameters to match those prices; * use the model to calculate values of other securities. Every few years the process has been repeated for a new asset class: * stock options: match stock and bond prices, calibrate volatility; * interest rates: match bond or swap prices, calibrate volatilities; * credit: match CDS prices, calibrate future default probabilities. 7 Underlyer Trouble
QuickTime and a TIFF (LZW) decompressor are needed to see this picture. 8 Emanuel Derman Prisma Capital Partners LP
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