The Black-Scholes Option

Pricing Model
Introduction
• The Black Scholes model, also known as the Black-Scholes-Merton
(BSM) model, is a mathematical model for pricing an options contract.
In particular, the model estimates the variation over time of financial
instruments such as stocks, and using the implied volatility of the
underlying asset derives the price of a call option.
• The Black-Scholes option pricing model (BSOPM) has been one of the
most important developments in finance in the last 50 years
-Has provided a good understanding of what options should sell for
-Has made options more attractive to individual and institutional
investors
The Model
C=St​N(d1)−Ke −rt N(d2​)

where:
d1 ​=​ln(St​/k)+(r+σ2​/2​)t /σs​  √t
​and
d2​= d1​−σs​  √ t​
where:
C=Call option price
S=Current stock (or other underlying) price
K=Strike price
r=Risk-free interest rate
t=Time to maturity
σ = standard deviation (sigma) of returns on the underlying security
N=A normal distribution​
ln = natural logarithm
Determinants of the Option
Premium
• Strike price
• Time until expiration
• Stock price
• Volatility
• Dividends
• Risk-free interest rate
Assumptions of the Black-
Scholes Model
• 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.
Limitations of the Black Scholes Model

• 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.
• 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.
• The model assumes that there are no transaction costs or taxes.
• 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.