- Length: 4 pages
- Sources: 5
- Subject: Economics
- Type: Essay
- Paper: #77624458
- Related Topics:
__Stock Valuation__,__Accounting Theory__,__Business Model__

The concept on which the Black-Scholes model is based is a normal distribution of asset returns, or that the underlying asset prices are in fact distributed lognormally (Hoadley, 2010). The main characteristic of a lognormal distribution in comparison with a normal bell curve is that the lognormal distribution exhibits a longer right tail (Hoadley, 2010). This type of distribution allows for any possible stock price between zero and infinity and does not allow for any negative prices (Hoadley, 2010). Furthermore, a lognormal distribution also exhibits an upward bias, which represents how a stock price can only drop 100% of its worth but can rise by more than 100% of its worth (Hoadley, 2010). However, distributions of underlying asset prices often significantly depart from the lognormal, and the pricing executed by the Black-Scholes model can be modified in order to effectively deal with non-lognormally distributed asset prices (Hoadley, 2010).

The most critical parameter that affects option pricing is volatility, which must be estimated as it cannot be observed directly (Hoadley, 2010). Implied volatility provides the price of an option, while historical volatility provides the value of an option. Furthermore, the value of an option is absolutely independent of the expected growth of an underlying asset, therefore rendering it risk-neutral (Hoadley, 2010). This constitutes the main reason why expected rate of return of a stock is not a variable in the Black-Scholes model (Hoadley, 2010). This functions to ensure objective agreement between different investors concerning the value of an option regardless of whether they agree or disagree about the future growth of the option (Hoadley, 2010). Therefore, the price determined by the Black-Scholes model is a risk-neutral valuation, and is essentially the compensation amount required by an option writer for writing a call and totally hedging the risk (Hoadley, 2010).

The main…

Crawford, Gregory. "A new model; The world of finance was changed when Myron Scholes and Fischer Black penned a paper on how to price an option.(P&I at 30: The class of '73)." Pensions & Investments. Crain Communications, Inc. 2003. HighBeam Research. 8 Dec. 2010

Cretien, Paul D. "Comparing option pricing models." Futures. . 2006. HighBeam Research. 8 Dec. 2010

Hoadley, Peter, (2010). Option pricing models and the 'Greeks'. Hoadley Trading and Investment Tools. Retrieved from http://www.hoadley.net/options/bs.htm 8 Dec. 2010.

McKenzie, Scott; Gerace, Dionigi; Subedar, Zaffar. "AN EMPIRICAL INVESTIGATION OF THE BLACK-SCHOLES MODEL: EVIDENCE FROM THE AUSTRALIAN STOCK EXCHANGE." Australasian Accounting Business & Finance Journal. University of Wollongong School of Accounting and Finance. 2007. HighBeam Research. 8 Dec. 2010