Black-Scholes Model

Origin of the Black-Scholes Model

How exactly did the Black-Scholes Model come about, you wonder? 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: \[ C = S_0e^{-qt}N(d_1) - Xe^{-rt}N(d_2) \] 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. 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. 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. 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.

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. 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.