Open in App
Log In Start studying!

Select your language

Suggested languages for you:
StudySmarter - The all-in-one study app.
4.8 • +11k Ratings
More than 3 Million Downloads
Free
|
|
Black-Scholes Model

Dive into the world of financial derivatives and risk management with this comprehensive guide on the Black-Scholes Model. Understand its origins, how to interpret its outputs, and how it's applied in real-world scenarios. Explore the assumptions it makes, including the risk-free rate, volatility, and normal distribution, and critically examine its limitations. This informative piece follows through with a worked-out example and concludes with the practical applications of the Black-Scholes Model in financial planning. An essential read to gain mastery over this fundamental tool in business studies.

Content verified by subject matter experts
Free StudySmarter App with over 20 million students
Mockup Schule

Explore our app and discover over 50 million learning materials for free.

Black-Scholes Model

Illustration

Lerne mit deinen Freunden und bleibe auf dem richtigen Kurs mit deinen persönlichen Lernstatistiken

Jetzt kostenlos anmelden

Nie wieder prokastinieren mit unseren Lernerinnerungen.

Jetzt kostenlos anmelden
Illustration

Dive into the world of financial derivatives and risk management with this comprehensive guide on the Black-Scholes Model. Understand its origins, how to interpret its outputs, and how it's applied in real-world scenarios. Explore the assumptions it makes, including the risk-free rate, volatility, and normal distribution, and critically examine its limitations. This informative piece follows through with a worked-out example and concludes with the practical applications of the Black-Scholes Model in financial planning. An essential read to gain mastery over this fundamental tool in business studies.

Understanding the Black-Scholes Model

The Black-Scholes Model, a finance-related concept, is a cornerstone in modern financial theory. You can use it for a lot of purposes, particularly when it comes to dealing with financial markets and options pricing. It sounds complex, but don't worry - you're about to unravel its secrets.

Origin of the Black-Scholes Model

How exactly did the Black-Scholes Model come about, you wonder?

The Black-Scholes Model was developed in 1973 by economists Fischer Black and Myron Scholes, with significant contributions from Robert Merton. It provides a theoretical estimate for the price of European-style options and derivatives.

Black and Scholes presented their model in a paper called "The Pricing of Options and Corporate Liabilities," published in the Journal of Political Economy. Since then, the Black-Scholes Model has become widely used in options trading.

Why use the Black-Scholes Option Pricing Model

The Black-Scholes Model can be applied to compute the theoretical price of European call and put options, disregarding any dividends paid out during the option's lifetime. A typical use of the Black-Scholes Model is to assess options in money-related markets. This model, no doubt, has the edge over certain other approaches. Here are some reasons why you should use the Black-Scholes Model:
  • Its assumptions about market behavior have been deemed plausible by numerous studies.
  • It is fairly straightforward to calculate, which is beneficial for time-sensitive financial decisions.
  • The model takes into account various factors affecting option prices, such as stock price, strike price, expiration date, volatility and risk-free interest rates.

Interpreting the Black-Scholes Model Outputs

So you've used the Black-Scholes Model. Now, how do you interpret the results? Following the model, the value of the option is typically expressed by this formula: \[ C = S_0e^{-qt}N(d_1) - Xe^{-rt}N(d_2) \]

Where \( C \) is the value of the call option, \( S_0 \) is the initial stock price, \( e \) is the base of natural logarithms, \( q \) is the dividend rate, \( N \) is the cumulative standard normal distribution function, \( t \) is the time until expiration in years, \( X \) is the strike price, \( r \) is the risk-free interest rate, and \( d_1 \) and \( d_2 \) are auxiliary variables used in the computation.

Once you plug in the numbers and complete the calculation using this formula, you'll get a value. This value can be interpreted as the theoretical fair value for the option based on the inputs used. If the current market price for the option is higher than this value, you might conclude that the option is overpriced, and vice versa. Remember, while this model provides a theoretical value, actual market prices can vary based on other factors like market sentiment, which the model does not account for.

Black Scholes Model Assumptions

The Black-Scholes Model operates on various assumptions to streamline the options pricing process. While convenience is a strong suit, it is important to remember that these assumptions may not hold true in all markets or situations. The chief assumptions of the Black-Scholes Model cover risk-free rate, volatility, and normal distribution.

Risk-free Rate Assumption in Black-Scholes Model

At the heart of the Black-Scholes Model lies the concept of the risk-free rate. The risk-free rate is a hypothetical rate of return that's expected from an investment with no risk.

The Risk-free rate refers to the interest an investor would expect to earn on an investment that carries zero risk, typically equated with the return on Government Treasury bills or bonds.

In the Black-Scholes Model, it is assumed that the risk-free rate is constant and known for the option's life. This assumption simplifies the model, as it negates the need to predict future interest rates. However, as you might imagine, this is rarely the case in reality. Interest rates fluctuate, and predicting them is a notoriously difficult task. The Black-Scholes Model formula, as noted before, is: \[ C = S_0e^{-qt}N(d_1) - Xe^{-rt}N(d_2) \] In this formula, \( r \) represents the risk-free rate. As such, the risk-free rate has a direct impact on the option price, affecting the discount rate used.

Volatility Assumption in the Black-Scholes Model

The Black-Scholes Model also makes an assumption on volatility.

Volatility refers to the degree of variation in a financial instrument's trading price series over time.

The model assumes that the volatility of the underlying asset is constant and known throughout the life of the option. Volatility, as assumed by the model, refers to the standard deviation of the asset’s returns. This can cause a discrepancy between the model's estimates and real prices because volatility tends to change over time. Volatility is notoriously hard to estimate and this assumption often results in pricing errors.

Normal Distribution Assumption

Next up is the assumption of the lognormal distribution of asset prices. The Black-Scholes Model operates under the assumption that the returns on the underlying asset are normally distributed. This stems from the assumption that the underlying asset's price movement can be described using a geometric Brownian motion with constant drift and volatility. But real-world asset returns exhibit skewness and kurtosis – that is, returns are not always symmetrical and can depart from the bell-shaped normal distribution. You should remember models are based on simplifying assumptions to make them tractable – perfect accuracy in modelling complex financial markets is nearly impossible, and the Black-Scholes Model is no exception.

Limitations of the Black-Scholes Model

While the Black-Scholes Model is widely used and highly respected, it's not a flawless tool. Like any model, it has limitations and critics. Some of the primary limitations come from the model's own assumptions, particularly about risk-free rates, volatility, and normal distribution. An understanding of these limitations can guide you in knowing when the model provides valuable insights, and when it may fall short.

Drawbacks of Assumptions in Black-Scholes Model

Despite the Black-Scholes Model's wide-ranging application and profound influence in the field of financial economics, its limitations arise from its assumptions, which are often at odds with reality. One key assumption of the Black-Scholes Model is that markets are perfectly efficient, and that arbitrage opportunities do not exist. In other words, it assumes that markets are always perfectly balanced, with securities always correctly priced. But in reality, markets are not always efficient and arbitrage opportunities occasionally present themselves. Another significant assumption is about dividends. The original Black-Scholes Model assumes that the underlying stock does not pay a dividend. However, many stocks do by nature, pay out dividends, which the model initially did not account for. More specifically, the assumptions related to risk-free rates and volatility also pose problems:
  • Constant Risk-Free Rate: The Black-Scholes Model assumes the existence and knowledge of a risk-free rate, which is used for discounting purposes. However, the risk-free rate is not constant in reality. It can change based on a myriad of factors including monetary policy and inflation expectations. Thus the assumption of a constant risk-free rate is usually inaccurate.
  • Constant Volatility: The assumption of constant volatility is often violated in real-world scenarios. Volatility tends to change over time and is frequently subject to "volatility clustering" - high-volatility periods tend to be followed by high-volatility periods, and low volatility periods by low volatility.
These assumptions simplify the reality to make the model theoretically and computationally tractable. However, they also limit the precision of the model in certain market scenarios.

Limitations of Black-Scholes Model Normal Distribution

A crucial and often criticised assumption of the Black-Scholes Model is that it assumes log-normal distribution of asset prices. This suggests that the asset prices have a tendency to rise as well as fall with the same probability. The model assumes that the returns of underlying assets are normally distributed. In consequence, 'extreme' events or outliers are considered unlikely. However, in practice, financial markets have shown that extreme price changes can happen, and more so than what normal distribution would suggest.

This assumption implicates that asset prices cannot fall below zero, and the potential upside for assets is virtually unlimited. However, the potential downside is limited by the fact that prices cannot drop below zero.

Reality begs to differ. Empirical observations of asset returns often demonstrate skewness and excess kurtosis, meaning returns can be asymmetrical and exhibit more extreme outcomes than anticipated under a normal distribution. This limitation became particularly visible in periods of financial crisis when extreme events happened more frequently than the model would predict. As a result of such limitations, the Black-Scholes Model, as helpful as it is, should be applied with caution and a good understanding of its assumptions and inherent limitations. For this reason, multiple variations on the classic Black-Scholes Model have emerged over time, attempting to address these problematic assumptions and provide a more accurate pricing tool for options in a complex and volatile market. One of such variations is the Black-Scholes-Merton Model, which provides for the pricing of options that pay dividends.

Black-Scholes Model Example

Now it's time to see the Black-Scholes Model in action. By stepping through a hands-on example, you can gain a clearer understanding of the role assumptions play in the model and how calculations are performed. Consider an example where all relevant information about an option and its corresponding share is available.

Black Scholes Model – A Worked Out Example

Let's take a hypothetical situation for a call option on a non-dividend-paying stock. We'll run through the Black-Scholes Model calculations using these inputs:
  • Stock price, \( S_0 = £1000 \)
  • Strike price, \( X = £100 \)
  • Time until expiration, \( T = 6 \) months or 0.5 years
  • Risk-free rate, \( r = 5\% \)
  • Volatility, \( \sigma = 20\% \)
Firstly, let's calculate \( d_1 \). \[ d_1 = \frac{ln(\frac{S_0}{X}) + (r + \frac{\sigma^2}{2})T}{\sigma\sqrt{T}} \] Insert the given values, and this gives us: \[ d_1 = \frac{ln(\frac{1000}{100}) + (0.05 + \frac{(0.2)^2}{2})0.5}{0.2\sqrt{0.5}} \approx 2.0494 \] Next, we calculate \( d_2 \): \[ d_2 = d_1 - \sigma\sqrt{T} \] Substitute the values: \[ d_2 = 2.0494 - 0.2\sqrt{0.5} \approx 1.8494 \] Once we have \( d_1 \) and \( d_2 \), we can find the value of the call option using the Black-Scholes formula: \[ C = S_0N(d_1) - Xe^{-rT}N(d_2) \] On the assumption that \( N(d_1) \approx 0.98 \) and \( N(d_2) \approx 0.97 \) from Standard Normal Tables, \[ C = 1000 \times 0.98 - 100 \times e^{-0.05 \times 0.5} \times 0.97 \approx £920.5 \] So, according to the Black-Scholes Model, the estimated value of the call option is approximately £920.5.

Note that the calculations required for the Black-Scholes Model rely heavily on our ability to calculate the probabilities contained within a standard normal distribution. For this reason, Standard Normal Distribution tables, which provide pre-calculated probabilities, can be an invaluable tool in performing these calculations.

From Assumptions to Calculations – An Example

To illustrate how the assumptions of the Black-Scholes Model apply in practice, let's return to our example of a call option for a non-dividend-paying stock. The option's parameters are the same: a stock price of £1000, a strike price of £100, 6 months until expiration, a 5% risk-free rate, and 20% volatility. The Black-Scholes Model's assumption of market efficiency implies that the stock's current price of £1000 fully reflects all publicly available information. Thus, there's no possibility of purchasing the stock for less than its fair market value or selling it for more. The constant risk-free rate assumption simplifies our calculations. We're using a risk-free rate of 5%. In practice, the risk-free rate might fluctuate during the lifetime of the option, but for our purpose, it stays constant. The assumption of constant volatility in the Black-Scholes Model allows us to use a volatility of 20% throughout the life of the option. Similarly, in a real market, volatility might fluctuate. Finally, we assume a lognormal distribution of the stock price. This involves a baseline assumption that the price of the underlying stock can theoretically rise to infinity while it cannot fall below zero. With these assumptions, you can understand how they reflect in the calculations of Black-Scholes Model as was illustrated in the previous example. Remember that the calculated price of the call option (£920.5) is based on these assumptions, and any deviation in the market scenario from these assumptions can affect the actual price of the option.

Black Scholes Model Uses

The Black-Scholes Model, on account of its simple structure and analytical tractability, has received widespread acceptance and continues to be a fundamental tool in finance. Its value derives especially from its ability to calculate the exact price of an option before it reaches its expiry date. But that’s not the extent of its applications. The Black-Scholes Model has many uses that extend beyond its original purpose. Let's delve into how it gets used practically in financial markets and how it might aid in financial planning.

Practical Applications of the Black-Scholes Model

One might wonder how a theoretical model like the Black-Scholes Model might be used in real-world scenarios. In reality, the model's practical applications are extensive.

Option pricing: The fundamental use of the Black-Scholes Model is in the pricing of options. It calculates the theoretical price of European put and call options, without considering any dividends paid during the option's lifetime.

But besides this core function, the model is also applied in areas like trading strategies, financial regulations, and risk management:
  • Trading strategies: Option traders also use the Black-Scholes Model to gain insights into trading decisions. They might use the model to identify options that are priced too high or too low in the market. These discrepancies offer trading opportunities, especially for arbitrage.
  • Financial regulations: Regulatory authorities use the Black-Scholes Model to calculate the fair price of options. This forms a part of their supervisory activities and helps ensure that markets are fair and transparent.
  • Risk management: Banks and other financial institutions use the Black-Scholes Model to manage risk. It helps them understand the price sensitivity of options to various factors – the underlying asset price, time to expiry, interest rates, and volatility. This information assists in structuring a risk-mitigation strategy.
Remember though: while the Black-Scholes Model can be an effective tool in option pricing and risk management, it is not without its limitations. Its underlying assumptions may not always hold true in real market conditions, leading to inaccuracies in option pricing. Therefore, any applications of the model should be done with caution.

Black-Scholes Model – A Tool for Financial Planning

Beyond the practical applications within the financial markets, you might wonder how this financial model pertains to individuals and their financial planning. While it might seem an odd fit at first, the Black-Scholes Model does indeed have uses in personal financial planning. Let’s consider an example. Say you have stock options in the company you work for. These stock options give you the right to buy the company's stock at a predetermined price in the future. The Black-Scholes Model can be used to estimate the value of these options today. The model can also be used to measure the potential risk of a financial portfolio containing options. By determining the responsiveness of option prices to changes in the underlying asset price, time to expiration, interest rates, and volatility, you can better understand the risk profile of your portfolio. This information can guide decisions about whether to hold or sell the options, potentially helping to optimize returns and manage risk. Furthermore, the Black-Scholes Model can also be applied in various other aspects of financial planning such as investment strategy and decision making, retirement planning, estate planning, and more. Again, caution is advised when using the Black-Scholes Model for these applications. The assumptions of the model aren't always met in the real world, and considering this discrepancy is important when applying the model to personal financial planning. However, when used correctly and with understanding, the Black-Scholes Model can indeed be a valuable tool for financial planning and decision-making.

Black-Scholes Model - Key takeaways

  • The Black-Scholes Model is used to calculate the theoretical fair value of an option, given certain input parameters. This formula is typically expressed as: C = S0e^-qtN(d1) - Xe^-rtN(d2).
  • The primary assumptions of the Black-Scholes Model are a constant risk-free rate, constant volatility, and a normal distribution of returns. These assumptions simplify the model, but may not always hold true in real market situations.
  • Key limitations of the Black-Scholes Model come from its assumptions about the risk-free rate, volatility, and normal distribution. The model also assumes market efficiency and does not initially account for dividends.
  • A practical example of the Black-Scholes model demonstrates how to calculate the theoretical fair value of a call option given certain inputs. In this example, the calculated call option price is £920.5.
  • The Black-Scholes Model has many practical uses beyond its primary function of pricing options, including in trading strategies, financial regulations, and risk management.

Frequently Asked Questions about Black-Scholes Model

The Black-Scholes model is used in financial markets to calculate the theoretical price of European-style options and derivatives. It aids in making decisions about investment strategies based on the predicted price.

The Black-Scholes model is a theoretical framework and while it can provide useful estimates, it doesn't account for all market variables. Therefore, its accuracy can be questioned. Its assumptions, particularly about volatility and risk-free rates being constant, often don't hold in real-world scenarios.

In the Black-Scholes model, volatility is a statistical measure that reflects the level of fluctuations in the price of a security or market index. It is a key input to options pricing, with higher volatility typically resulting in higher option prices.

The Black-Scholes model is calculated through a mathematical formula involving five variables: current stock price, option exercise price, time until exercise, risk-free interest rate, and volatility of the stock price. The formula is fairly complex and usually requires computer software to compute accurately.

The Black-Scholes model is important as it provides a theoretical estimate for the price of options and derivatives. It enables investors to gauge the risk and potential reward of financial instruments, and is extensively used in trading and risk management.

Final Black-Scholes Model Quiz

Black-Scholes Model Quiz - Teste dein Wissen

Question

Who developed the Black-Scholes Model and when was it introduced?

Show answer

Answer

The Black-Scholes Model was developed in 1973 by economists Fischer Black and Myron Scholes, with significant contributions from Robert Merton. It was first presented in a paper titled "The Pricing of Options and Corporate Liabilities".

Show question

Question

What is a typical use of the Black-Scholes Model?

Show answer

Answer

The Black-Scholes Model is typically used to compute the theoretical price of European call and put options, excluding any dividends paid out during the option's lifetime. It is commonly used in options trading.

Show question

Question

How is the theoretical fair value of an option interpreted from the Black-Scholes Model output?

Show answer

Answer

The theoretical fair value of an option derived from the Black-Scholes Model is compared with the current market price. If the market price is higher, the option may be overpriced and vice versa.

Show question

Question

What does the Black-Scholes Model assume about the risk-free rate?

Show answer

Answer

The Black-Scholes Model assumes that the risk-free rate, or the return expected from an investment with no risk, is constant and known for the option's life.

Show question

Question

According to the Black-Scholes Model, what is the assumption made about volatility?

Show answer

Answer

The Black-Scholes Model assumes that the volatility, which refers to the degree of variation in the underlying asset's price, is constant and known throughout the life of the option.

Show question

Question

What is the assumption made about the distribution of asset prices in the Black-Scholes Model?

Show answer

Answer

The Black-Scholes Model assumes that the returns on the underlying asset are normally distributed.

Show question

Question

What key assumption does the Black-Scholes Model make about markets and arbitrage opportunities?

Show answer

Answer

The Black-Scholes Model assumes that markets are perfectly efficient, and that arbitrage opportunities do not exist.

Show question

Question

What are some assumptions made in the Black-Scholes Model concerning risk-free rates and volatility?

Show answer

Answer

The model assumes a constant risk-free rate and constant volatility; both of these assumptions are typically inaccurate in reality as both rates and volatility can fluctuate.

Show question

Question

How does the Black-Scholes Model view asset price distribution and what is a limitation of this view?

Show answer

Answer

The model assumes a log-normal distribution of asset prices, suggesting equal probabilities of prices rising and falling. However, this view does not account for actual market extremes which are more frequent than the model suggests.

Show question

Question

What are the key parameters in this example of the Black-Scholes Model?

Show answer

Answer

A stock price of £1000, a strike price of £100, 6 months until expiration, a 5% risk-free rate, and 20% volatility.

Show question

Question

What assumptions does the Black-Scholes Model make in this example?

Show answer

Answer

Market efficiency (stock price reflects all information), a constant risk-free rate, constant volatility, and lognormal distribution of the stock price.

Show question

Question

According to the Black-Scholes Model, what is the estimated value of the call option in this example?

Show answer

Answer

The estimated value of the call option is approximately £920.5.

Show question

Question

What is the primary use of the Black-Scholes Model in finance?

Show answer

Answer

The primary use of the Black-Scholes Model in finance is in the pricing of European put and call options, without considering any dividends paid during the option's lifetime.

Show question

Question

How can the Black-Scholes Model assist in personal financial planning?

Show answer

Answer

The Black-Scholes Model can be used in personal finance to estimate the value of stock options, measure potential risk of a portfolio containing options, and guide decisions in aspects such as investment strategy, retirement planning, and estate planning.

Show question

Question

In which areas, apart from option pricing, is the Black-Scholes Model applied?

Show answer

Answer

Apart from option pricing, the Black-Scholes Model is also applied in areas like trading strategies, financial regulations, and risk management.

Show question

Question

What is the Black Scholes Formula?

Show answer

Answer

The Black Scholes Formula is a mathematical model used to calculate the theoretical price of options. It was developed by economists Fischer Black and Myron Scholes and is widely used in corporate finance and investment strategy.

Show question

Question

What are the components of the Black Scholes Formula?

Show answer

Answer

The Black Scholes Formula includes the current price of the underlying stock (S_t), the cumulative standard normal distribution function (N), the option exercise price (X), the exponential function (e), the risk-free interest rate (r), and the time to option maturity (T - t).

Show question

Question

How is the Black Scholes Formula used in practice?

Show answer

Answer

The Black Scholes Formula is used to estimate the fair value of a call option. It can provide valuations for company stock options, calculate the fair price of options in mergers and acquisitions, or even assess executive pay packages.

Show question

Question

What does a put option in the Black Scholes Formula represent?

Show answer

Answer

A put option is a financial contract that provides an investor the right to sell shares of an underlying security at a specified price, known as the strike price, until the option expires.

Show question

Question

What variables are considered in the Black Scholes formula for a put option?

Show answer

Answer

The variables are the current price of the underlying security (St), the strike price of the option (X), time until the option's expiration (T - t), the risk-free interest rate (r), and the volatility of the security's returns (σ).

Show question

Question

What distinguishes European and American Put Options in the Black-Scholes Model?

Show answer

Answer

A European Put Option can only be exercised at the time of maturity while an American Put Option can be exercised at any time before its expiration date. The Black Scholes model is specifically developed for European options.

Show question

Question

What is the key purpose of the Black Scholes Call Option Formula?

Show answer

Answer

The Black Scholes Call Option formula is used to compute the theoretical price of options. It considers factors like the current stock price, the strike price, time until expiration, the risk-free interest rate, and the volatility of the asset.

Show question

Question

What does each symbol in the Black Scholes Call Option Formula represent?

Show answer

Answer

In the formula, C is the pricing of the call option, S_t is the current stock price, N represents the cumulative standard normal distribution, X signifies the strike price of the option, e is the base of the natural logarithm, r represents the risk-free interest rate, and T-t is the time until the option expires.

Show question

Question

How does the Black Scholes Call Option Formula account for volatility?

Show answer

Answer

The Black Scholes Call Option formula uses the standard deviation of the asset's returns (denoted by σ in d_1 and d_2 parts of the formula) as a measure of volatility.

Show question

Question

What is the Black Scholes formula used for?

Show answer

Answer

The Black Scholes formula is a fundamental model for option pricing in modern financial theory. It suggests replicating the payoff of an option by continuously adjusting a hedging portfolio consisting of the risk-free asset and the underlying stock.

Show question

Question

What assumptions does the Black Scholes formula make for its validity?

Show answer

Answer

The Black Scholes formula assumes the underlying security follows a geometric Brownian motion with constant volatility, no transaction costs or penalties for short selling, and a constant risk-free rate and volatility.

Show question

Question

How does Gamma function in the Black-Scholes model and what role does it play?

Show answer

Answer

In the Black-Scholes model, Gamma is the rate of change of an option's Delta, which itself measures the rate of change of the option price with respect to changes in the underlying asset's price. Thus, Gamma accounts for how much the Delta changes as the asset's price changes.

Show question

Question

What are the key components of the Black Scholes formula and what do they represent?

Show answer

Answer

The Black Scholes formula comprises three primary parts: underlying asset price times \(N(d1)\), strike price discounted at a risk-free rate times \(N(d2)\), and the difference between these two. The first part represents the future expected benefit, the second part signifies the future cost, and the formula balances these by discounting to the present using risk-neutral measures.

Show question

Question

What assumptions underpin the Black Scholes model?

Show answer

Answer

The Black Scholes model's assumptions include: the underlying stock price follows a geometric Brownian motion, no transaction costs exist nor penalties for short selling, the market operates continuously, the risk-free rate is constant and equal for borrowing and lending, and the option can be exercised only at expiry.

Show question

Question

How does the Black Scholes formula apply in real-world scenarios?

Show answer

Answer

In the real world, traders substitute known variables like the underlying asset price, strike price, volatility, time to expiration, and risk-free rate into the Black Scholes formula. The calculated theoretical option price provides a benchmark for whether to buy, sell, or hold the option.

Show question

Test your knowledge with multiple choice flashcards

Who developed the Black-Scholes Model and when was it introduced?

What is a typical use of the Black-Scholes Model?

How is the theoretical fair value of an option interpreted from the Black-Scholes Model output?

Next

Flashcards in Black-Scholes Model30

Start learning

Who developed the Black-Scholes Model and when was it introduced?

The Black-Scholes Model was developed in 1973 by economists Fischer Black and Myron Scholes, with significant contributions from Robert Merton. It was first presented in a paper titled "The Pricing of Options and Corporate Liabilities".

What is a typical use of the Black-Scholes Model?

The Black-Scholes Model is typically used to compute the theoretical price of European call and put options, excluding any dividends paid out during the option's lifetime. It is commonly used in options trading.

How is the theoretical fair value of an option interpreted from the Black-Scholes Model output?

The theoretical fair value of an option derived from the Black-Scholes Model is compared with the current market price. If the market price is higher, the option may be overpriced and vice versa.

What does the Black-Scholes Model assume about the risk-free rate?

The Black-Scholes Model assumes that the risk-free rate, or the return expected from an investment with no risk, is constant and known for the option's life.

According to the Black-Scholes Model, what is the assumption made about volatility?

The Black-Scholes Model assumes that the volatility, which refers to the degree of variation in the underlying asset's price, is constant and known throughout the life of the option.

What is the assumption made about the distribution of asset prices in the Black-Scholes Model?

The Black-Scholes Model assumes that the returns on the underlying asset are normally distributed.

Join over 22 million students in learning with our StudySmarter App

The first learning app that truly has everything you need to ace your exams in one place

  • Flashcards & Quizzes
  • AI Study Assistant
  • Study Planner
  • Mock-Exams
  • Smart Note-Taking
Join over 22 million students in learning with our StudySmarter App Join over 22 million students in learning with our StudySmarter App

Sign up to highlight and take notes. It’s 100% free.

Start learning with StudySmarter, the only learning app you need.

Sign up now for free
Illustration