In chapter 5, we touched on the problem of options pricing. Recall, we saw that the option premium (i.e., price) depends positively on the payoff, time to expiration, and volatility of the underlying asset.
A major breakthrough in finance and economics in the 20th century was the development of the Black-Scholes option pricing formula, which solved the problem of how to get the correct price of an option.
While the formula itself is quite mathematically complex and outside our scope, the story of options and the development of the Black-Scholes formula is intertwined with the story of international financial markets and investment and global financial crisis.
Also, although B-S was originally developed for pricing stock options, the formula for currency options is very similar. In fact, Black-Scholes is ultimately based on the same type of no-arbitrage reasoning that we have seen throughout the session.
In particular, they find that cash, risky assets (i.e., stocks, currencies, etc.) and options themselves can be used together to form a riskless portfolio.
Since riskless assets must by definition earn the risk-free rate (otherwise, arbitrage would be possible), the price of the option can then be solved.
Besides the mathematical complexity behind the formula, it was this familiar no-arbitrage type of reasoning that earned the Black-Scholes formula the Nobel Prize in Economics.
In addition to the development of the B-S formula, the video brings together many concepts that we have seen in class this semester, including (in no particular order):
- No-arbitrage pricing
- Market efficiency vs. forecasting
- Statistical methods for characterizing returns and measuring risk
- Risk transfer role of derivatives and hedging
- Derivatives trading and exchanges
- International capital flows and investment
- Currency crisis and contagion
Besides these, the video also gives a great glimpse into the world of academic finance, the inner workings of financial markets and institutions, and the nature of financial crises.
While you are watching, note the similarity between what got us into trouble back then and what got us into trouble today (e.g., excessive debt/leverage to fuel a property boom, underassessment of risk and/or overconfidence in our ability to deal with risk, government bailouts, etc.).
Assignment:
Choose any five (5) of the bullet points above and discuss the topic further by describing what we learned in class about the topic and linking it to specific parts of the video in which it is mentioned or occurs. A two to three paragraph discussion for each point should suffice, totaling 2-3 pages for the entire assignment.