Black Scholes Model
Updated on March 20, 2023
Used frequently by option traders, Black Scholes Model is an important concept in finance. It was initiated by Robert Merton and developed by Fischer Black and Myron Scholes in 1973. It is used for mathematically calculating prices of calls and puts with a risk adjusted framework. The model uses current price, estimated dividend, option’s strike price, expected rate of interest, time for expiry and volatility for the calculation. Traders buy options which are priced below the calculated value as per Black Scholes Method and sell options which are priced higher than the calculated value.
By using this method, the trader tries to hedge the buying and selling of options with minimum risk and a greater chance of gains.
Key assumptions under Black Scholes Model
The Black Scholes Model is based on certain assumptions for arriving at the desired result :
a. No dividends are paid during the time duration of option
b. Markets will be volatile
c. Risk free rate is known and will be constant
d. Options can only be executed at expiration