The Black-Scholes Model is a mathematical model used to calculate the theoretical price of options. It was developed in 1973 by economists Fischer Black and Myron Scholes, with contributions from Robert Merton. The principles behind the model are rooted in the idea that markets are efficient and that the movement of asset prices can be predicted through a linear, or ‘normal’, distribution.
The entire calculation is built around five primary variables: the current price of the asset, the option’s strike price (the price at which the asset can be bought or sold using the option), the time until the option expires, the risk-free interest rate, and the volatility of the asset. The model assumes constant volatility and interest rates throughout the option’s life.
While the model may seem complex, its primary purpose is to help investors and traders assess whether an option is overpriced or underpriced. Although it’s widely used and regarded as an integral part of financial theory, the Black-Scholes Model should be used with caution, as its assumptions do not always hold in the real world. Market conditions can change rapidly, and unpredictable events can disrupt the assumed normal distribution of asset prices.
