Question

Critically assess the merits and shortcomings of the Black Scholes Pricing Model on the
Stock Exchange of Mauritius.

Answer 1

Answer:

The Black-Scholes model, also known as the Black-Scholes-Merton (BSM) model, is a mathematical model for pricing an options contract. In particular, the model estimates the variation over time of financial instruments.

Explanation:

Understanding Black Scholes Model

The Black-Scholes model is one of the most important concepts in modern financial theory. It was developed in 1973 by Fischer Black, Robert Merton, and Myron Scholes and is still widely used today. It is regarded as one of the best ways of determining the fair price of options. The Black-Scholes model requires five input variables: the strike price of an option, the current stock price, the time to expiration, the risk-free rate, and the volatility.

Black-Scholes Assumptions.

The Black-Scholes model makes certain assumptions:

The option is European and can only be exercised at expiration.

No dividends are paid out during the life of the option.

Markets are efficient (i.e., market movements cannot be predicted).

There are no transaction costs in buying the option.

The risk-free rate and volatility of the underlying are known and constant.

The returns on the underlying asset are log-normally distributed.