Option value model.

Option Pricing Theory

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From the partial differential equation in the model, known as the Black—Scholes equationone can deduce the Black—Scholes formula, which gives a theoretical estimate of the price of European-style options and shows that the option has a unique price regardless of the risk of the security and its expected return instead replacing the security's expected return with option value model risk-neutral rate.

The formula led to a boom in options trading and provided mathematical legitimacy to the activities of the Chicago Board Options Exchange and other options markets around the world. Merton was the first to publish a paper expanding the mathematical understanding of the options pricing model, and coined the term "Black—Scholes options pricing model".

Merton and Scholes received the Nobel Memorial Prize in Economic Sciences for their work, the committee citing their discovery of the risk neutral dynamic revision as option value model breakthrough that separates option value model option from the risk of the underlying security.

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This type of hedging is called "continuously revised delta hedging " and is the basis of more complicated hedging strategies such as those engaged in by investment banks and hedge funds.

The model's assumptions have been relaxed and generalized in many directions, leading to a plethora of models that are currently used in derivative pricing and risk management. It is the insights of the model, as exemplified in the Black—Scholes formulathat are frequently used by market participants, as distinguished from the actual prices.

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These insights include no-arbitrage bounds and risk-neutral pricing thanks to continuous revision. Further, the Black—Scholes equationa partial differential equation that governs the price of the option, enables pricing using numerical methods when an explicit formula is not possible.

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The Black—Scholes formula has only one parameter that cannot be directly observed in the market: the average future volatility of the underlying asset, though it can be found from the price of other options. Since the option value whether put or call is increasing in this parameter, it can be inverted to produce a " volatility surface " that is then used to calibrate other models, e.

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