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Black Scholes Model in Finance

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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RAHUL kumar
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13 views8 pages

Black Scholes Model in Finance

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.

Uploaded by

RAHUL kumar
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

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
[Link]@[Link]
[Link]

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