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An Unhedgeable Black–Scholes–Merton Implicit Option?

Author

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  • Alfredo M. Pereira

    (Department of Economics, William & Mary, Williamsburg, VA 23187, USA)

  • M. Sean Tarter

    (Department of Applied Science, William & Mary, Williamsburg, VA 23187, USA)

Abstract

In this paper, we focus on an implicit assumption in the BSM framework that limits the scope of market network connections to seeking gains in the currency basis, i.e., on trading strategies between the numeraire and the stock and between the numeraire and the option, separately. We relax this assumption and derive the equivalent of the standard BSM approach under a more general market network framework in order to assess its implications. In doing so, we find that it is not possible to hedge on an implicit option that allows one to directly trade the option and stock. This represents a potential challenge to the BSM framework, since the missing market network connection provides a potentially useful mechanism for risk-bearing portfolio managers to alter their portfolios.

Suggested Citation

  • Alfredo M. Pereira & M. Sean Tarter, 2022. "An Unhedgeable Black–Scholes–Merton Implicit Option?," Risks, MDPI, vol. 10(7), pages 1-12, June.
    • Handle: RePEc:gam:jrisks:v:10:y:2022:i:7:p:134-:d:851550
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    References listed on IDEAS

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