THE BLACK SCHOLES MODEL

Final Presentation
Sumitted to Zeeshan Raza
Contents
Introduction to Black Scholes Model ............................................................................................................ 1
Evolution of Black Scholes ............................................................................................................................ 2
Assumptions.................................................................................................................................................. 2
Formula ......................................................................................................................................................... 3
Benefits ......................................................................................................................................................... 3
Limitations .................................................................................................................................................... 4
References .................................................................................................................................................... 5

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Introduction to Black Scholes Model
The Black Scholes model, also known as the Black-Scholes-Merton model, is a model of price
variation over time of financial instruments such as stocks that can, among other things, be
used to determine the price of a European call option. 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.

Evolution of Black Scholes

FISCHER BLACK MYRON SCHOLES BOB MERTON

Assumptions
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.

Additionally the Model assumes;

Stock prices follow a lognormal distribution because asset prices cannot be negative.
There are no transaction costs or taxes.
The risk-free interest rate is constant for all maturities.
Short selling of securities with use of proceeds is permitted.
There are no riskless arbitrage opportunities.

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Formula
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, C = S*N(d1) -
Ke^(-r*T)*N(d2). Conversely, the value of a put option could be calculated using the formula: P
= Ke^(-r*T)*N(-d2) - S*N(-d1). In both formulas, S is the stock price, K is the strike price, r is the
risk-free interest rate and T is the time to maturity. The formula for d1 is: (ln(S/K) + (r +
(annualized volatility)^2 / 2)*T) / (annualized volatility * (T^(0.5))). The formula for d2 is: d1 -
(annualized volatility)*(T^(0.5)).

Benefits
The main advantage of the Black-Scholes model is that it is relatively easy to understand and
use to calculate prices. Because of this, it has become a standard way to quote prices, and more
importantly, to translate between prices. This is done by using the (Black-Scholes) implied
volatility.

For example, suppose you have some model you like to use, and it quotes a price of $1 for a call
option. Given that price, the current stock price, time to expiration, etc., you can calculate the
volatility for the stock that would yield a Black-Scholes price of $1.

This is useful, because what traders are "really" interested in is buying expected returns, and
the price they pay is taking on risk, in terms of volatility. This idea ties in to the "market price of
risk", which, in theory, is the same for an option and its underlying. If the underlying has more
volatility than the Black-Scholes implied volatility, you can capture arbitrage by purchasing
options and selling shares, etc.

The Black-Scholes model is an attempt to simplify the markets for both financial assets and
derivatives into a set of mathematical rules. The model serves as the basis for a wide range of
analysis of markets.

The main advantage of the model is that it works entirely on objective figures rather than
human judgment. Another benefit is that, although complex for human calculation, the formula
is relatively simple in mathematical terms, so it does not require a sophisticated computer
program to make calculations.

The main use of the model is to deal with options pricing. The options contract system means
that the buyer of the contract can sell his position in the deal to another party before the
completion date.

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Limitations
As stated previously, the Black Scholes model is only used to price European options and does
not take into account that American 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.

Main merit of the BSM approach is its simplicity in application, the BSM model was developed
purely theoretical, leaving most of the literature on option pricing theory to question its
assumptions: their unrealistic nature may prevent the model from producing accurate
predictions when tested empirically

One of the most noted shortcomings of the model is related to the way the volatility term is
computed. Measurement errors in the option price determinants, such as volatility, cause
misleading predictions. In order to clearly show how this affects the models predictions, a
distinction between explicit and implicit volatility is necessary

Asset indivisibility assumption is violated because very often option contracts are traded in
blocks on organised exchanges, hence the impossibility of trading in a single option from that
block. Furthermore, in practice, dynamic hedging is not feasible due to market frictions such as
excessive transaction costs, and discontinuous trading

The above mentioned difficulties in applying the model can result in discrepancies between the
observed market prices of options and the prices predicted by the Black-Scholes formula. As a
result, the literature on derivatives pricing has found additional relevant factors that determine
the prices of option contracts

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References

Khan Academy, Introduction to black scholes model.