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  • Module 8 - BSM

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    RAHUL kumar
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    The document discusses the Black-Scholes model for pricing options. It outlines the key assumptions of the model, including that the price of the underlying asset follows a lognormal distribution and that volatility and interest rates are constant. It also discusses how the Black-Scholes partial differential equation can be solved to arrive at a formula for pricing calls and puts. Finally, it notes that while Black-Scholes introduced the concept of a complete market, continuous hedging is not truly possible, and extensions to the model have incorporated time-varying inputs like interest rates and volatility.

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    Financial derivatives -Black scholes model

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    The document discusses the Black-Scholes model for pricing options. It outlines the key assumptions of the model, including that the price of the underlying asset follows a lognormal distribution and that volatility and interest rates are constant. It also discusses how the Black-Scholes partial differential equation can be solved to arrive at a formula for pricing calls and puts. Finally, it notes that while Black-Scholes introduced the concept of a complete market, continuous hedging is not truly possible, and extensions to the model have incorporated time-varying inputs like interest rates and volatility.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
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    9 views8 pages

    Module 8 - BSM

    Uploaded by

    RAHUL kumar
    The document discusses the Black-Scholes model for pricing options. It outlines the key assumptions of the model, including that the price of the underlying asset follows a lognormal distribution and that volatility and interest rates are constant. It also discusses how the Black-Scholes partial differential equation can be solved to arrive at a formula for pricing calls and puts. Finally, it notes that while Black-Scholes introduced the concept of a complete market, continuous hedging is not truly possible, and extensions to the model have incorporated time-varying inputs like interest rates and volatility.

    Copyright:

    © All Rights Reserved
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    of 8

    Black Scholes model

    Ameya Abhyankar
    Founder, FinQuest Institute
    Agenda
    ▪Basics of quantitative finance
    ▪ Assumptions of the Black Scholes model
    ▪ Solution to the Black Scholes PDE [formula for Call and Put option]
    ▪ Understanding the meaning of complete markets
    ▪ Some enhancements applied to the basic assumptions of the Black
    Scholes framework
    ▪Application of Black Scholes model
    Basics of Quantitative finance
    ▪ Mean, standard deviation, variance
    ▪ Concept of Returns
    ▪ Normal distribution
    ▪ Lognormal distribution
    ▪ A few other important distributions in Finance [Poisson, Uniform, Bivariate etc.]
    ▪ Markov process [can it be used for path dependent options?]
    ▪ General equation for stock price diffusion process
    ▪ Scaling of mean and standard deviation with time
    ▪ Meaning of a Weiner process and its relevance to quantitative finance [for arriving at asset price
    random walk in continuous time]
    Assumptions of Black Scholes model
    ✓ Assumptions of Black Scholes model
    ▪ Price of the underlying follows a lognormal distribution
    ▪ Risk free rate is constant and known
    ▪ Volatility of the underlying asset is constant
    ▪ No restrictions on borrowing and lending rates and they are equal
    ▪ There are no dividends paid on the underlying stock
    ▪ There are no arbitrage opportunities
    ▪ Markets are friction less
    ▪ Options are European in nature
    ✓ Black Scholes can be derived using a combination of principles of Ito’s , delta hedging and no-
    arbitrage
    ✓ Finite Difference is a popular approach for solving the PDE. [aside: Final Conditions, Boundary
    Conditions]
    Formula for Call and Put using BS
    Complete Markets and Enhancements to the
    model assumptions
    ✓ What are Complete Markets?
    ✓ Is continuous delta hedging possible at all times?
    ✓ Enhancements applied to the model parameters:
    ❑Models implemented based on the black Scholes framework have added a few enhancements
    to the basic assumptions underlying the basic equation
    ➢ Time dependent interest rates
    ➢ Time dependent volatility
    ➢ Adjusting for dividend payment on the underlying stock
    Application of Black Scholes model
    ▪ Black Scholes is a very popular model for option pricing and used by both front office as well as the
    middle office teams in banks, financial institutions
    ▪ Used extensively for constructing the option volatility surface
    ▪ Well understood by almost all market participants
    ▪ Acceptable model for periodic fair valuation of options for the purpose of financial reporting by
    companies
    ▪ BS model can be used by banks for arriving at the capital allocation as required under regulatory
    guidelines
    ▪ Many other advanced models for option pricing take their inspiration from the Black Scholes
    framework
    Thank You
    abhyankar.ameya@gmail.com
    www.finquestinstitute.com

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