Applications of the Black-Scholes Model

Some of the common applications of Black-Scholes Model are:

• Options Pricing: It aids in determining the fair price of options, which is critical for investors and traders making educated purchasing or selling choices.

• Risk Management: By knowing the fair value of options, traders may better control their risk exposure and minimize possible losses.

• Option Strategies: By giving insights into option price dynamics, the model helps to build various option trading strategies such as hedging and speculating.

• Derivatives Valuation: In addition to options, it may be used to evaluate other derivative securities, offering a framework for determining the value of financial instruments having comparable features.

Limitations of Black Scholes Model

The Black-Scholes Model has drawbacks even if it offers insightful information:

• Frictions in the Market: The model does not take into consideration the transaction fees and levies that are present in real-world marketplaces.
• Volatility Assumption: The idea that market volatility is constant is false since market volatility fluctuates.
• Asset Price Movements: The model makes the assumption that asset prices would always fluctuate, which may not always be the case.

Read More,

• What are Derivatives and How it Works?
• What are Options Contracts?
• What are Futures Contracts?
• Difference Between Options and Futures

The potential cost of European-style options is determined using a mathematical model called the Black-Scholes Model. With Robert Merton’s help, economists Fischer Black and Myron Scholes created it in 1973, revolutionizing options pricing and laying the groundwork for contemporary quantitative finance. The concept is widely used in financial markets to value options on stocks, commodities, currencies, and other types of assets.

In this article, we will discuss the formula that helps us calculate the prices of options using the Black-Scholes Model and also see some solved examples for it.