The Black-Scholes and Merton method of modelling derivatives prices was first introduced in 1973, by the Nobel Prize winners Black, Scholes (1973) and Merton (1973), after which the model is named. Essentially, the Black-Scholes-Merton (BSM) approach shows how the price of an option contract can be determined by using a simple formula of the underlying asset’s price and its volatility, the exercise price – price of the underlying asset that the contract stipulates – time to maturity of the contract and the risk-free interest rate prevailed in the market". (i) Critically assess the merits and shortcomings of the Black Scholes Pricing Model on the Stock Exchange of Mauritius. (15 Marks) (ii) Discuss the other relevant alternatives of the BSM approach on the Stock Market of Market. (10 marks)
Answers
Explanation:
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The option-pricing model developed by Black, Scholes and Merton (BSM) in 1973 offers a "straightforward" way of "computing" the option contracts' prices, and being widely used by traders.
Explanation:
Merits of BSM
By utilising the information given in the "option contract" & the "estimated volatility" of the "underlying asset price" one can easily ascertain the option price using BSM formulas. The study of the BSM model’s "assumptions & predictions" other researchers to widen its applicability to other "contingent claims" such as "line-credit agreements" & "insurance contracts".
Shortcomings of BSM
The shortcomings emerge from an "unrealistic set of assumptions" that lead to difficulties in "estimation & evaluating" the "model’s predictions". One of the keyd drawbacks of the BSM model is connected to the way the "volatility" term is computed. "Measurement errors" in the option price determinants, like volatility result in "misleading predictions". So as to clearly demonstrate how this impacts the "model’s predictions", a distinction between “implicit” & “explicit” volatility is essential .
Alternatives of the BSM approach on the Stock Market of Market.
- The BSM analysis could be applied to "contingent claims" – securities which have returns that are dependent on the "returns of other assets".
- Another significant applications of the BSM approach to “option-like” securities is pricing of "insurance contracts" like "deposit insurance policies" & "loan guarantees"
- Yet another application of the BSM analysis is in revolving credit agreements/ line of credit agreements, that are contracts similar to options that is, a firm that needs finance for its projects "signs an agreement" with another firm who is "obliged" to lend/loan to it the amount required in case this is asked for/requested.
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