Option Pricing Theory And Its Unintended Consequences

Abstract

Like any revolution, the options revolution that began with the publication of the Black-Scholes-Merton option pricing formula has had some unintended side effects. Of concern to all investors should be the potentially dangerous increase in market instability created by the trading strategies option sellers use to hedge their market exposures. Dynamic hedging rules that call for buying as market prices rise and selling as they fall have wreaked havoc with markets in the past and are likely to do so again in the future.

Keywords: option pricing, Black-Scholes-Merton option pricing theory, options, OTC options, option replication, option dealers, synthetic options, hedging options, dynamic hedging, portfolio insurance, market instability, market liquidity, 1987 crash

JEL Classification: G10, G13