[heading size="7"]Black Scholes Pricing Model[/heading]

The Black-Scholes Pricing Model was the first option pricing model is the granddaddy of them all and has been the basis for many subsequent models. The Black Scholes model is probably the best-known and most popular options pricing model. Formulated in 1973 by Fisher Black and Myron Scholes, this model won them the Nobel Prize in economics in 1997.

 Even though it was an award winner, the Black-Scholes Model had its flaws. The Black Scholes pricing model was originally supposed to calculate the price of European-style options. European options do not allow for early exercise like American-style options do. European-style options are very much like futures in this way. The main problem with Black-Scholes model is and does not account for (price) the ability of her early exercise of American options. It doesn’t account for exercising early to collect interest rate or the dividend. Further, as you go out over time, the model loses integrity. Since the original version, the Black-Scholes Pricing Model has been modified to adjust for this deficiency. This adaption is also known as a modified Black Scholes Model.

 After the Black Scholes model came out and its weaknesses were identified, Cox, Ross, and Rubenstein developed the Binomial Pricing  Model. The binomial model was based on the same concepts as the Black Scholes model. The intent was to develop a model that was very similar to the Black Scholes in its speed and accuracy but adjusted for early exercise and for better integrity over time. That is what the binomial model does. To this day, more people use the Cox Ross and Rubenstein binomial model than the Black-Scholes Pricing Model.

 

Option Theory