Interview Question: When BS Doesn’t Work

Sample Question #89 (finance – options pricing)

What are some of the reasons why Black-Scholes may not work in the real world?

(Comment: too many candidates I’ve interviewed simply memorize formulas and definitions without understanding what’s behind those formulas and definitions)

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One Response to Interview Question: When BS Doesn’t Work

  1. Brett says:

    ANSWER
     
    There are many reasons why the assumptions behind Black-Scholes are violated. For example:
     
         – short-selling is not possible or readily available (e.g., the up-tick rule)
         – liquidity constraints in the stock prevent arbitrage opportunities
         – non-linear transaction costs that are unknown ex ante
         – volatility moves around wildly even during short time periods
         – wrong interest rate used (I guess this does happen!)
     

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