# Black Scholes Model

Search Dictionary

## Definition of 'Black Scholes Model'

The Black-Scholes model is a mathematical model that describes the dynamics of a financial instrument's price over time. It is used to price options, which are financial contracts that give the buyer the right to buy or sell an underlying asset at a specified price on or before a specified date.

The Black-Scholes model was developed by Fischer Black and Myron Scholes in 1973. It is based on the assumption that the price of an option is determined by the underlying asset's price, the strike price of the option, the time to expiration, and the volatility of the underlying asset.

The Black-Scholes model is a powerful tool for pricing options, but it has some limitations. For example, it assumes that the underlying asset's price follows a geometric Brownian motion, which is a continuous, random walk. In reality, asset prices often exhibit jumps, which the Black-Scholes model does not account for.

Despite its limitations, the Black-Scholes model is still widely used by investors and traders to price options. It is a valuable tool for understanding the risks and rewards of investing in options.

The Black-Scholes model is a complex mathematical formula, but it can be simplified to make it more understandable. The following is a simplified version of the Black-Scholes model:

```
C = SN(d1) - Ke-rT N(d2)

P = Ke-rT N(-d2) - SN(-d1)
```

where:

* C is the price of a call option
* P is the price of a put option
* S is the price of the underlying asset
* K is the strike price of the option
* r is the risk-free interest rate
* T is the time to expiration of the option
* N(x) is the cumulative distribution function of the standard normal distribution

The first term in the equation for C represents the intrinsic value of the call option, which is the difference between the strike price and the underlying asset's price. The second term represents the time value of the call option, which is the value of the option's ability to appreciate in value over time.

The first term in the equation for P represents the intrinsic value of the put option, which is the difference between the underlying asset's price and the strike price. The second term represents the time value of the put option, which is the value of the option's ability to depreciate in value over time.

The Black-Scholes model can be used to price options on a variety of underlying assets, including stocks, bonds, commodities, and currencies. It is a valuable tool for investors and traders who want to understand the risks and rewards of investing in options.

The Black-Scholes model has been used to price options for over 40 years, and it is still considered to be one of the most important and influential models in finance. It has been used to price trillions of dollars worth of options, and it has helped to make options a popular investment tool.

The Black-Scholes model is not without its critics. Some people argue that it is too complex and that it makes unrealistic assumptions about the behavior of asset prices. Others argue that the model is not as accurate as it is often made out to be.

Despite these criticisms, the Black-Scholes model remains a valuable tool for understanding and pricing options. It is a complex model, but it is also a powerful one. The Black-Scholes model has helped to make options a more accessible and popular investment tool, and it is likely to continue to play an important role in the financial markets for many years to come.

Do you have a trading or investing definition for our dictionary? Click the Create Definition link to add your own definition. You will earn 150 bonus reputation points for each definition that is accepted.

Is this definition wrong? Let us know by posting to the forum and we will correct it.