Abstract 2
Introduction: 3
Literature Review: 4
1. Options & its characteristics 4
2. Black Scholes Pricing Model 6
Assumptions 6
I. Constant volatility 6
II. No Dividends 6
III. European exercise terms are used 6
IV. Markets are efficient 7
V. No commissions are charged 7
VI. Interest rates remain constant and known 7
VII. Returns are lognormal distributed 7
VIII. Liquidity 7
4. Inputs to the Black-Scholes Model 9
I. The underlying price 9
II. The exercise price 9
III. Time to expiration 9
IV. The risk-free rate 9
V. Volatility 9
5. Limitations of Black Scholes Model 10
6. Macro-economic Variable Effect: 12
Methodology: 13
Analysis: 14
Limitations: 19
Recommendations: 20
Conclusion: 21
References: 22
Abstract
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Black Scholes Pricing Model
In 1973, Myron Scholes and Fisher Black developed the framework on option pricing and presented the theory in their seminal paper. With reference to both approach and application the Black Scholes Model is considered to be one of the most significant concepts in modern financial theory. For valuing options the Black Sholes Model is viewed as a standard model.
Assumptions
To compute the value of a stock option the Black-Scholes Option Pricing Model is used. Both call and put option can be calculated with the help of the model. For the accurate application of the Black Scholes Pricing Model it is necessary to be familiar with its assumptions. Black and Scholes specified the following assumptions in their seminal paper (1973). (Ray, 2012)
I. Constant volatility
Volatility refers to the movement of the stock price whether upwards or downwards. The model assumes that the volatility does not change and is known to market participants. This implies that the variance of the return remains constant over the life of the option.
II. No Dividends
The model assumes that the underlying asset (stock) does not pay any dividends during the option’s life.
III. European exercise terms are
to determine a stock's implied value, money is top dog. Numerous models that evaluate the actual value of security select elements that directly influence profits and future monetary streams, and most importantly, present value these cash flows use the time estimation of cash. One model famously utilized for discovering an organization's inborn worth is the
When employing decisions to whether investing will be an option, there are three main equations typically used within market-based ratios.
7. A valuation of the stock or a range of values that would provide a basis for an investment decision. Include the assumptions you make and your calculation steps. You may calculate the stock's required return from an SML or APT
In order to set the option pricing model, other basic assumptions have been used such as the market is efficient and frictionless which means that people cannot predict with consistency the direction of stocks in the financial market; no tax or transaction costs occur and there are no legal restrictions on trading in the options and in the underlying asset, or on short-selling the asset (Data and Mathews, 2004; Jiang, 2005). The BSM model also assumes that the market is arbitrage free which indicates there
In such a way to study the topic, we will discuss first the Net Asset Value and its advantages and disadvantages, then the Discounted cash flow method and to finish the dividend discount model.
Black, F. & Scholes, M., 1973. The Pricing of Options and Corporate Liabilities. The Journal of
The standard method of calculating a stock price using the perpetual dividend growth model is done by assessing a company’s dividend one year into the future adding the future expected growth rate. The formula is written as: P0 = D1/(Ke − g), where Ke is the investor required return, D1 is next year’s dividend and g is the
7. A valuation of the stock or a range of values that would provide a basis for an investment decision. Include the assumptions you make and your calculation steps. You may calculate the stock's required return from an SML or APT equation.
¡§Economic Theory Suggests that Markets are Efficient and Security Prices are Determined on the Basis of Fundamental Value¡¨
These models are very similar, they are based on similar theoretical foundations and have a series of assumptions, such as; Geometric Brownian Motion and risk-neutral valuation. However, both models have unique differences which are foundational in there model, some of which are highlighted below.
The Black-Scholes formula for valuing options was the first numeric formula for pricing European call options. Santos et. al., (2014) argue that Fisher Black and Myron Scholes’s formula is rooted in Modigliani and Miller’s non-arbitrage proposition. The model holds the following assumptions: a) the risk-free rate is known and constant over time; b) the asset pays no dividends; c) the option can only be exercised at its maturity date; d) there are no transaction cost when buying or selling an asset or its derivate; e) it is possible to invest any fraction of assets or derivate to the risk free interest rate; f) there are no penalties when selling short; g) the model is developed from the concept that the option asset price has a continuous stochastic behaviour,
The analysis starts with the valuation of 20 American put options with the same set of parameters usually considered in the literature, implemented by Longstaff and Schwartz as well. The following Table 4.1 presents the results of pricing estimation of 20 options resulting from the combination of the following parameters:
The standard Black-Scholes model for call-option and put-option pricing, assuming risk neutrality and proper discounting, is as follows:
Ever since Ross (1976) proposed the Arbitrage Pricing Theory (APT) as an alternative to the capital pricing model, many economists and investors have applied APT across different markets. Whereas the traditional capital pricing model explained asset returns with one beta, sensitivity to the market return, APT decomposes the return with a multiple number of factors. This idea became particularly popular for investors who aim to gain systematic risk other than market risk. However, the model specification aspect has been challenging to many practitioners as the theory does not require any specific sets of variables to be used (Azeez 2006).
Despite this, however, some have since suggested that their model is pure economics, and is only valid in a theoretical world that doesn’t reflect some of the frictions that actual financial markets do.