Black-Scholes Model

The Black-Scholes model is a formula created to determine the fair value

of options and other financial derivatives.
How the Black-Scholes Model Works

The Black-Scholes model is a complete formula used to calculate the price of an

option or other financial derivative. With all the financial inputs in place, the model
produces a price for the option. This also allows traders to figure out the impact of
changing other variables in the formula and see the potential impact that would have
on the price of the option in question.

BSM Model Variables

The Black-Scholes model uses many data points that are obtained from observable
features of the financial markets to operate. These include:

 Stock Price: Current price of the stock

 Option Strike: The strike price of the option

 Expiry: The amount of time until the option expires

 Risk-Free Rate: What investors can earn on cash or short-term

government bonds.

 Volatility: The amount of volatility investors expect in a stock.


Assumptions of the BSM Model

 A Riskless Asset: The Black-Scholes model works by comparing a

risky asset to a risk-free asset such as treasury bills.

 No Dividend: The financial asset won't pay out dividends during the life
of the option contract.

 Random Walk: Prices behave in a random manner, and are not

correlated from one period to the next.
  No Transaction Limits: Market participants can buy or sell as many
securities at one time as they wish without limits.

 No Transaction Fees: The model assumes market participants aren't

limited by brokerage fees.

 No Arbitrage: The model assumes there is no way to benefit from

differing prices for the same financial asset.

 Option Is European Format: The Black-Scholes model is for options

which can't be exercised prior to the expiration date.

Black-Scholes Formula

The Black Scholes formula can be written out as follows below:

The above holds using the following parameters:

 C: Call option price

 S: Current stock price

 K: The option's strike price

 r: The risk-free rate of return

 t: Time remaining until contract expiry

  N: Normal distribution
From that basic formula, there are other more specific variations. There's the call—or
European call formula—for determining the price of call options in particular. There's
also a put option version for dealing with the put side of the option ledger.

Important: This model is for European-style options, that is to say options which cannot
be exercised until the time that they expire. Adjustments must be made for American-
style options which can be exercised prior to expiration.

Benefits of the Black-Scholes Model

 Simplifies Option Pricing: By making the other variables of option

pricing constants, it puts the emphasis on the effects of time and
volatility in relation to an asset price. This simplification, while at times
general, allows for easy and quick pricing of options which might
otherwise be harder to value.

 Easy For Hedging: Due to the set of assumptions made in the model,
a Black-Scholes practitioner can easily hedge between the options
market and the other financial instruments involved (namely the
underlying stock and the risk-free cash instrument).

 Widely Used And Accepted: The Black-Scholes is the most prevalent

options pricing framework out there and thus using it is likely to result
in options pricing close to what other market participants have in their
own spreadsheets.

 Speed: The simplifications within the model make it possible to

calculate a vast number of options prices quickly. Other more
sophisticated methods may be slightly more accurate but take longer
to output results.
Limitations of the Black-Scholes Model

 Volatility Isn't Constant: Newer research shows volatility tends to vary

over time and also over strike price. Arguably, the 1987 crash, in part,
was due to mispriced options thanks to the so-called volatility smile
 and market makers not pricing out-of-the-money options at sufficiently
high premiums.

 Liquidity Isn't Infinite: The Black-Scholes model assumes that market

participants can transact as much stock as they want without
changing market prices. During market crashes, liquidity often
disappears, temporarily invalidating this premise.

 Risk-Free Rate Isn't Constant: While interest rates are generally stable,
sometimes, such as in 2022, they move at a rapid clip, causing long-
term options priced at one interest rate to become significantly
mispriced.

 Assumes Price Changes Are Normally Distributed: Some critics of the

Black Scholes model, such as Nassim Taleb, argue that stocks do not
follow a standard distribution of returns and that they experience
outsized moves more frequently than the model would predict. This
has serious implications for the pricing of out-of-the-money options.

 Assumes Prices Are A Completely Random Walk: The model works

on the basis that price changes are completely random. However,
academic research has shown that prices may have some momentum;
that is to say stocks going up have a tendency to keep going up in the
intermediate term and vice versa.