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Purpose of pricing models

Joined
5/22/23
Messages
67
Points
168
Hello,

I'm still quite new to the world of quant finance, and I have been having a question that I can't really get an answer to, I'm not actually sure this question even makes sense. This might just be a reasoning issue that I'm having, so someone could probably enlighten me with a simple answer. Why do companies spend millions in research to develop new models for the pricing of options (or any other financial instrument)? At the very end, isn't the market going to decide for the price of those instruments? Let's imagine the whole market uses the "basic" Black-Scholes model to price a specific call option (let's say the BS call price is $10). Now, a certain quant comes up with a new, state-of-the-art model, that gives a more "mathematically" accurate price for the same call option (let's say $15). In that case, how can this model be used in practice, when everyone else is selling the call for $10? Why would someone suddenly decide to pay a higher price for an option, only based on the fact that it is more "mathematically accurate"? In fact, if every company use different models to price a specific derivative, isn't the market simply going to choose the one that has the lowest price?
 
That's like saying the market is gonna choose the lowest price for any stock. Why waste time and money reading financial statements to figure out the true accurate value of a stock like Buffett does. We need to do this because the market can be wrong and will eventually catch up to the more accurate model. Of course, with the caveat that markets can be slow to adjust. if a new model suggests that a call option is worth $15 while the market is pricing it at $10, it doesn't automatically mean that someone will pay $15 right away. However, it indicates that the option might be undervalued. Traders using this model might start buying the option at $10, and if enough market participants recognize this value discrepancy and act similarly, the market price could indeed move towards $15.
 
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