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5 Cards in this Set
- Front
- Back
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What are the assumptions of the Black Scholes Pricing Model?
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-Only applies to EUROPEAN OPTIONS (options which can only be exercised on their expiry date), unlike American options which can be exercised at any time during the life of the option, making American options more valuable due to their greater flexibility
-Assumes NO transaction costs, perfect divisibility, and information is freely available to all investors (Based on a NO ARBITRAGE PRICING MODEL) -Assumes NO imperfections exist in short sales of shares or options -Assumes SHORT-TERM INTEREST RATE is known and constant throughout the period of the option and all investors can borrow/lend at this rate (unique interest rate for investors to borrow/lend at) -Assumes The shares PAY NO dividends over the life of the option (as dividends will impact the option values). Most companies pay dividends to their shareholders so this might seem a serious limitation to the model considering the observation that higher dividend yields elicit lower call premiums -Assumes share prices follow a random walk over time - SO the variance of the return is CONSTANT (doesn't change) over the life of the option (we don't care what happens after the life of the option) and known to investors. -Assumes NORMAL DISTRIBUTION (i.e. returns on the underlying stock are normally distributed, which is reasonable for most assets that offer options) and EFFICIENT MARKETS - where shares represent all information relevant to their values |
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What are the Advantages of the Black Scholes Model?
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-Black Scholes model has proved very flexible, it can be adapted to value options on a variety of assets such as foreign currencies, bonds and commodities
-It can be used by dealers who are not trained in the formula's mathematical derivation via a computer or specially programmed calculator to find the value of the option -The model recognizes a continuum of possible outcomes - This is usually more realistic than the limited number of outcomes assumed in the binomial model -The formula is also more accurate and quicker to use than the binomial method -Model allows you to calculate a very large number of option prices in a very short time |
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What are the variables affecting Option prices?
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1) Share Price 2) Exercise price 3) Volatility
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Limitations of the Black Scholes model?
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-Black Scholes cannot be used to accurately price options with an AMERICAN style exercise as it only calculates the option price at one point in time - at expiration (it doesn't consider the possibility of early exercise). The BINOMIAL MODEL can be used to accurately price American options
-Black Scholes cannot accurately price options which pay dividends, which many do -Assumes no transaction costs (which interfere with the arbitrage process and reduce gains, so the price can drift away from the no-arbitrage price) -Short SALES RESTRICTIONS interfere with the arbitrage process -Assumes (a unique rate for) risk free lending/borrowing - NOT TRUE -Assumes normal distribution and efficient markets - not always true -Dividends can't be forecasted into the future |
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Binomial model?
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+ve _ its more transparent
+ve _ gives more information about when would be the right time to exercise +ve _ more flexibility when you assume upward or downward parameters - more realistic -ve _ more parameters means there is more subjectivity |
