Could you define please what BS is an abbreviation for? This question
might be a bit naive, however I do not come from a physics background
but am an ex trader. If it is the same thing as an equilibrium price,
then I think it is almost pure math. Not quite, though. I agree with
Soros that the whole idea of markets trending towards an equilibrium
is a false premise. One has to remember that not only the products
make up a market but mostly the players do. And in order to have a
liquid market you need many different actors in a market with
different needs, goals and time horizons. So what might be an
irrational price for one actor, might not be for another, because he
has a different time horizon in mind when he buys the product,than the
person who sells it. He/she is allowed or not to take on a different
degree of risk before getting hit by his credit committee or other
reasons. So as you say we verify the price not the theory. An example
which is very common to somebody in the markets is a long term
investor will find the price of an asset to high but a trader at a
major firm might think also the asset is too pricey but thinks he can
make profit on it in the next ten minutes. Or one trader might be
making money on a position simple because he didn't hedge it when he
bought it and the market goes up so he will be willing to sell.
However another trader with exactly the same time frame might hedge
what he bought by selling something else and has to make money aganist
his hedge before selling, even though they might have the same time
horizon when they bought the asset. This happens all the time. So you
create volatility which creates more instable systems which takes you
even further from the so called equilibrium price. Like I said I think
this in itself is a false premise for most products. 

Hope this is of some help, reflect any thoughts back 
 



---Kirill N Ilinski <[log in to unmask]> wrote:
>
> Hi Stefan,
> 
> > Please allow me to ask the somewhat provokative question if for this
> > particular area there are any techniques in physics that are
really more
> > proficient than those used by the mathematicians today (mainly
stochastic
> > calculus and the Feynman-Kac equation).
> 
> I have been working on corrections to BS using physical ideas.
> Basicly, the question is if no-arbitrage condition is restrictive or
> not. The no-arbitrage is an analogue of an equilibrium point and
> virtual "arbitrage" opportunities (even if they are inside bids-ask+
> transactions) may, in principle, influence the price (and hedge).
> From physical point of view it looks like dynamics to the equilibrium.
> This dynamics can be fast (for liquid markets) or can be slow (for
> not so liquid markets). Sometimes we have to take it into account
> (in physical terms this is a question of characteristic time scales).
> Then, if you allow these "arbitrage", duplication methodology becames
> somewhat obscure and there is a need in another paradigm.
> 
> Let me write about things which I am now thinking about.
> The question is "Is BS indeed a "true" price?"
> All standard  explanations keep saying that "if price below BS we buy,
> if higher - we sell and so do others; this keeps price close to BS
and,
> hence, BS is stable true price". However, since there are different
> views on the underlying asset dynamics, economic enviroment and so on,
> anybody sees his own BS as a "true" price. It means that it may well
> appear buyers when the theory tells us to sell. Hence, for
derivatives,
> as for other assets, we have beliefs which actually define the price
> rather then theory. From my own (not very rich) experience I know that
> traders know what to do and need assistance of quants only to get an
> estimate for exotic deals (correct me, please, if I am wrong). These
> estimates are usually pritty rough and do not involve all this
> complicated math. So, at the end of the day, these are traders beliefs
> which defines the market movements. Therefore, use of BS is
analogues to
> using the equilibrium market theory (from which, by the way, Merton
> derived BS) for asset pricing. No need to say that number of people
> already criticized equilibrium market and Soros is just most
successful
> and emotional practitioner among them. Summing up, BS may be
misleading.
> Does it mean that all this fuss around BS is pure math?
> 
> I personnaly think that this the dynamics which physicists can bring
> in the financial economics (not only derivatives).
> 
> regards,
> 
> kirill
> 

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