Question

Why does the Black Sholes model work better than the Monte Carlo or Binomial pricing model, What determines this condition?

Answer 1

The main advantage of the Black-Scholes model is speed it lets you calculate a very large number of option prices in a very short time. Since, high accuracy is not critical for American option pricing . So by using Black-Scholes is a good option. But the option of using the binomial model is also advisable for the relatively few pricing and profitability numbers where accuracy may be important and speed is irrelevant. You can experiment with the Black-Scholes model using on-line options pricing calculator. Here this method is very simple and easy to understand. So most probably this method is used by the stockholders for easy identification of stock value.

   In case pf binomial model here time to expiration into a number of time intervalsis considered. in each stage the model predicts two possible movements of the stock pricelike upward or downwaed and then the amount calculated using the volatility and time to expiration of the stock. Monte Carlo simulation uses computerized modeling to predict outcomes. The model first generates a random number based on a probability distribution. The random number then uses the additional inputs of volatility and time to expiration to generate a stock price. The generated stock price at the time of expiration is then used to calculate the value of the option. So since it is using the computerised model it is bit difficult to identify the steps and giving inputs.

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