Sunday, January 3, 2010


Black and Scholes Model (B-S Model) For Option Valuation

The logic of valuing a call option, as discussed in the previous posts, is quite simple. The framework can, however, be extended beyond two periods. We can also make the time period and the movement in the share price very small. The computation would be quite complex, fortunately, we can use the Black and Scholes (B-S0 model.

Which, under certain assumption, can be used for valuing options as the time period becomes continuous.


The Black and Scholes (B-S) model is based on the following assumptions,
  • The rates of return on a share are log normally distributed.
  • The value of the share (the underlying asset) and the risk free rate of are constant during the life of the option.
  • The market is efficient and there are no transaction costs and taxes.
  • There is no dividend to be paid on the share during the life of the option.

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