What it is:
The Black-Scholes model is a formula used to assign prices to European options.
How it works/Example:
The model is named after Fischer Black and Myron Scholes, who developed it in 1973. Robert Merton also participated in the model's creation, and this is why the model is sometimes referred to as the Black-Scholes-Merton model. All three men were college professors working at both the University of Chicago and MIT at the time.
The model assumes the option price follows a Geometric Brownian motion with constant drift and volatility. Among other more complicated variables, the formula takes into consideration the price of the underlying stock, the strike price of the option, and the amount of time before the option expires. Clearly, computers have greatly eased and extended the use of the Black-Scholes model.
The basic mission of the Black-Scholes model is to calculate the probability that an option will expire in the money. To do this, the model looks beyond the simple fact that the value of a call option increases when the underlying stock price increases or when the exercise price decreases. Rather, the model assigns value to an option by considering several other factors, including the volatility of XYZ Company stock, the time left until the option expires, and interest rates. For example, if XYZ Company stock is considerably volatile, there is more potential for the option to go in the money before it expires. Also, the longer the investor has to exercise the option, the greater the chance that an option will go in the money and the lower the present value of the exercise price. Higher interest rates raise the price of the option because they lower the present value of the exercise price.
It is important to note that the Black-Scholes model is geared toward European options. American options, which allow the owner to exercise at any point up to and including the expiration date, command higher prices than European options, which allow the owner to exercise only on the expiration date. This is because the American options essentially allow the investor several chances to capture profits, whereas the European options allow the investor only one chance to capture profits.
Why it matters:
Empirical studies show that the Black-Scholes model is very predictive, meaning that it generates option prices that are very close to the actual price at which the options trade. However, various studies show that the model tends to overvalue deep out-of-the-money calls and undervalue deep in-the-money calls. It also tends to misprice options that involve high-dividend stocks. Several of the model's assumptions also make it less than 100% accurate. First, the model assumes that the risk-free rate and the stock's volatility are constant. Second, it assumes that stock prices are continuous and that large changes (such as those seen after a merger announcement) don't occur. Third, the model assumes a stock pays no dividends until after expiration. Fourth, analysts can only estimate a stock's volatility instead of directly observing it, as they can for the other inputs. Analysts have developed variations of the Black-Scholes model to account for these limitations.
Ultimately, however, the Black-Scholes model represents a major contribution to the efficiency of the options and stock markets, and it is still one of the most widely used financial tools on Wall Street. Besides providing a dependable way to price options, it helps investors understand how sensitive an option's price is to stock price movements. This in turn helps investors maximize the efficiency of their portfolios by giving them a way to calculate hedge ratios and more effectively implement portfolio insurance.
Despite the tremendous efficiencies created by the Black-Scholes model, many financial theorists claim the model's introduction indirectly increased the volatility of the stock and options markets by encouraging more trading (as investors sought to constantly fine-tune their hedge positions). Others claim the model actually steadies the markets because of its ability to measure equilibrium pricing relationships. When these relationships are violated, arbitrageurs are usually the first to discover and exploit mispriced options.