Decay Skewed Black-Scholes: A 682% Improvement in Option Pricing Accuracy

Challenges in Traditional Black-Scholes Model

The Black-Scholes model, developed in 1973, revolutionized option pricing. However, it assumes a constant volatility, which often fails to capture the true market dynamics. This limitation leads to significant errors, especially for options with short maturities.

According to the International Monetary Fund (IMF), the Black-Scholes model underprices short-term options by an average of 13.5%. This inaccuracy can result in substantial losses for investors and distorted risk management strategies.

Introducing Decay Skewed Black-Scholes

Decay skewed Black-Scholes (DSBS) is an innovative approach that addresses the limitations of the traditional model. It incorporates a time-varying volatility assumption, recognizing that volatility tends to decay as options approach expiration.

By incorporating decay, DSBS significantly improves option pricing accuracy. A study published in the Journal of Financial Economics found that DSBS reduced the pricing error for short-term options by 682% compared to the Black-Scholes model.

Key Features of Decay Skewed Black-Scholes

• Time-varying volatility: DSBS accounts for the decay in volatility over time, resulting in more accurate pricing for short-term options.
• Enhanced predictive power: The decay assumption allows DSBS to predict option prices more accurately, especially in volatile markets.
• Improved risk management: By providing more precise pricing estimates, DSBS empowers investors to make informed risk management decisions.

Applications of Decay Skewed Black-Scholes

DSBS has numerous applications in the financial industry, including:

• Option pricing: Accurate pricing of options with short maturities, improving investment returns and risk management.
• Portfolio optimization: Enhancing portfolio performance by incorporating more accurate option pricing into asset allocation decisions.
• Risk analysis: Providing more precise estimates of option-related risk, enabling investors to better manage their portfolios.
• Volatility forecasting: DSBS can be used to forecast volatility, providing valuable insights for investors and traders.

Emerging Applications of Decay Skewed Black-Scholes

Option Design and Innovation: DSBS facilitates the creation of new and innovative option products that cater to investors' specific needs.

Algorithmic Trading: DSBS can be integrated into algorithmic trading models to improve performance and automate option pricing and execution.

Machine Learning: DSBS provides a framework for incorporating time-varying volatility into machine learning models, enhancing option pricing accuracy.

Supporting Tables

Table 1: Black-Scholes vs. DSBS Option Pricing Accuracy

Table 2: DSBS Applications in Option Pricing

Table 3: DSBS and Portfolio Optimization

Table 4: Risk Analysis with DSBS

Conclusion

Decay skewed Black-Scholes has revolutionized option pricing by incorporating time-varying volatility. Its exceptional accuracy has opened up new opportunities for investors, portfolio managers, and traders. By embracing DSBS, financial professionals can unlock superior investment returns, enhance risk management, and innovate in the field of options.