Black-Scholes Model

Posted: August 26th, 2021

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Black-Scholes Model

            The Black-Scholes model makes several assumptions in the pricing of call and put options. In my opinion, the underlying assumption in the model that volatility is constant in the period under analysis is the most problematic. This is the most significant assumption in the model as it ignoresthe measure of stock movement in a particular period, which is presumed to remain constant. The volatility of a stock can be relatively steady in the short-term, but it can never remain unchanged in the long-term in the real investment world. Furthermore, volatility has a substantial impact on the pricing of options as it keeps changing over time with price highs and lows. Thus the model assuming constant volatility is unrealistic.

           Additionally, the equation presumes a lognormal distribution in the price variations of the underlying asset. The distribution that is referred to as the Gaussian distribution indicates that the prices of the underlying assets have significant skewness and kurtosis. However, the model overlooks that the prices of options are highly volatile, especially, in the long run. More so, the volatility of options also affects jumps in the market as a result of releasing good or bad news. Therefore, when an investor is anticipating increasing volatility, he should purchase options, and in case of decreasing volatility, he should sell options. Thus, an ideal pricing model should take into account the short-term and long-term price changes by considering the relationship between future price and volatility as well as volatility-of-the-volatility.