Question

What are the assumptions of the Black-Scholes Option Pricing Model? Discuss each assumption

Answer 1

Assumptions of Black-Scholes Option Pricing Model :

1) Efficient markets : It assumes that market or stock movements can not predicted. It can go down or up at any time.

2) Volatility : Volatility can be constant in very short term as assumed. It measures how much stock is expected to move in short term.

3) European options : It assumes european style options which excercised only on the expiration date.

4) Dividends : There is assumption that stock does not pay any dividends during the life of options.

5) Returns : Returns on underlying stock is normally distributed.

6) Constant interest rate : Intetest rate is also assumed to be constant. It uses risk free rate to represent the constant rate.

7) Liquidity : It is assumed that market is liquid & stocks or options can be bought or sold at any given time.

8) No transaction cost : It assumes that there is no transaction costs or commission for buying or selling options or stocks.