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The Basics of The Black Scholes Model

The Black-Scholes model is a widely used pricing model for options developed in 1973. It calculates the theoretical value of options based on inputs like the current stock price, strike price, time to expiration, risk-free interest rate, and volatility. The model assumes stock prices follow a lognormal distribution and that options can only be exercised at expiration for European options. While widely adopted, it has limitations like assuming constant volatility and dividends and not considering transaction costs.

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Sheila Mae Araman
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49 views4 pages

The Basics of The Black Scholes Model

The Black-Scholes model is a widely used pricing model for options developed in 1973. It calculates the theoretical value of options based on inputs like the current stock price, strike price, time to expiration, risk-free interest rate, and volatility. The model assumes stock prices follow a lognormal distribution and that options can only be exercised at expiration for European options. While widely adopted, it has limitations like assuming constant volatility and dividends and not considering transaction costs.

Uploaded by

Sheila Mae Araman
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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BLACK SHOLES

The Basics of the Black Scholes Model


The model assumes the price of heavily traded assets follows a geometric
Brownian motion with constant drift and volatility. When applied to a stock option,
the model incorporates the constant price variation of the stock, the time value of
money, the option's strike price, and the time to the option's expiry.

Also called Black-Scholes-Merton, it was the first widely used model for option
pricing. It's used to calculate the theoretical value of options using current stock
prices, expected dividends, the option's strike price, expected interest rates, time
to expiration and expected volatility.

The formula, developed by three economists—Fischer Black, Myron Scholes and


Robert Merton—is perhaps the world's most well-known options pricing model. It
was introduced in their 1973 paper, "The Pricing of Options and Corporate
Liabilities," published in the Journal of Political Economy. Black passed away two
years before Scholes and Merton were awarded the 1997 Nobel Prize in
Economics for their work in finding a new method to determine the value of
derivatives (the Nobel Prize is not given posthumously; however, the Nobel
committee acknowledged Black's role in the Black-Scholes model).

The Black-Scholes model makes certain assumptions:

 The option is European and can only be exercised at expiration.


 No dividends are paid out during the life of the option.
 Markets are efficient (i.e., market movements cannot be predicted).
 There are no transaction costs in buying the option.
 The risk-free rate and volatility of the underlying are known and constant.
 The returns on the underlying are normally distributed.

While the original Black-Scholes model didn't consider the effects of dividends
paid during the life of the option, the model is frequently adapted to account for
dividends by determining the ex-dividend date value of the underlying stock.

The Black Scholes Formula


The mathematics involved in the formula are complicated and can be
intimidating. Fortunately, you don't need to know or even understand the math to
use Black-Scholes modeling in your own strategies. Options traders have access
to a variety of online options calculators, and many of today's trading platforms
boast robust options analysis tools, including indicators and spreadsheets that
perform the calculations and output the options pricing values.
The Black Scholes call option formula is calculated by multiplying the stock price
by the cumulative standard normal probability distribution function. Thereafter,
the net present value (NPV) of the strike price multiplied by the cumulative
standard normal distribution is subtracted from the resulting value of the previous
calculation.

In mathematical notation:

\begin{aligned} &C = S_t N(d _1) - K e ^{-rt} N(d _2)\\


&\textbf{where:}\\ &d_1 = \frac{ln\frac{S_t}{K} + (r+ \frac{\sigma ^{2}
_v}{2}) \ t}{\sigma_s \ \sqrt{t}}\\ &\text{and}\\ &d_2 = d _1 - \sigma_s \
\sqrt{t}\\ &\textbf{where:}\\ &C = \text{Call option price}\\ &S =
\text{Current stock (or other underlying) price}\\ &K = \text{Strike
price}\\ &r = \text{Risk-free interest rate}\\ &t = \text{Time to maturity}\\
&N = \text{A normal distribution}\\ \end{aligned}C=StN(d1)−Ke−rtN(d2
)where:d1=σs tlnKSt+(r+2σv2) tandd2=d1−σs t
where:C=Call option priceS=Current stock (or other underlying) priceK=S
trike pricer=Risk-
free interest ratet=Time to maturityN=A normal distribution
Volume 75%

1:33
Black-Scholes Model
What Does the Black Scholes Model Tell You?
The Black Scholes model is one of the most important concepts in modern
financial theory. It was developed in 1973 by Fischer Black, Robert Merton,
and Myron Scholes and is still widely used today. It is regarded as one of the
best ways of determining fair prices of options. The Black Scholes model
requires five input variables: the strike price of an option, the current stock price,
the time to expiration, the risk-free rate, and the volatility.

The model assumes stock prices follow a lognormal distribution because asset
prices cannot be negative (they are bounded by zero). This is also known as
a Gaussian distribution. Often, asset prices are observed to have significant
right skewness and some degree of kurtosis (fat tails). This means high-risk
downward moves often happen more often in the market than a normal
distribution predicts.
The assumption of lognormal underlying asset prices should thus show that
implied volatilities are similar for each strike price according to the Black-Scholes
model. However, since the market crash of 1987, implied volatilities for at the
money options have been lower than those further out of the money or far in the
money. The reason for this phenomena is the market is pricing in a greater
likelihood of a high volatility move to the downside in the markets.

This has led to the presence of the volatility skew. When the implied volatilities
for options with the same expiration date are mapped out on a graph, a smile or
skew shape can be seen. Thus, the Black-Scholes model is not efficient for
calculating implied volatility.

Limitations of the Black Scholes Model


As stated previously, the Black Scholes model is only used to price European
options and does not take into account that U.S. options could be exercised
before the expiration date. Moreover, the model assumes dividends and risk-free
rates are constant, but this may not be true in reality. The model also assumes
volatility remains constant over the option's life, which is not the case because
volatility fluctuates with the level of supply and demand.

Moreover, the model assumes that there are no transaction costs or taxes; that
the risk-free interest rate is constant for all maturities; that short selling of
securities with use of proceeds is permitted; and that there are no risk-less
arbitrage opportunities. These assumptions can lead to prices that deviate from
the real world where these factors are present.

Definition of 'Black-scholes Model'


Definition: Black-Scholes is a pricing model used to determine the fair price or theoretical
value for a call or a put option based on six variables such as volatility, type of option,
underlying stock price, time, strike price, and risk-free rate. The quantum of speculation
is more in case of stock market derivatives, and hence proper pricing of options eliminates
the opportunity for any arbitrage. There are two important models for option pricing –
Binomial Model and Black-Scholes Model. The model is used to determine the price of a
European call option, which simply means that the option can only be exercised on the
expiration date.

Description: Black-Scholes pricing model is largely used by option traders who buy
options that are priced under the formula calculated value, and sell options that are priced
higher than the Black-Schole calculated value (1).
The formula for computing option price is as under (2):

Call Option Premium C = SN(d1) - Xe- rt N(d2)

Put Option Premium P = Xe–rT N (–d2) – S0 N (-d1)

d1 = [Ln (S / X) + (r + s2 / 2) X t] -------------------------------------- s Öt d2 = [Ln (S / X) + (r -


s 2 / 2) X t] --------------------------------------- s Öt

Here,

C = price of a call option

P = price of a put option

S = price of the underlying asset

X = strike price of the option

r = rate of interest

t = time to expiration

s = volatility of the underlying

N represents a standard nor

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