4 - Black-Scholes Option Pricing Model

Question 1

what does weak form market efficiency mean?

Answer 1

historical info can’t help you predict future prices

Question 2

the binomial model has discrete time and discrete variables, what does the black scholes model have?

Answer 2

continuous time and continuous variable

Question 3

what number of days per year should you use as the denominator when calculating stock prices? for black schoels?

Answer 3

260 - stock prices don’t change when stock markets are closed
365

Question 4

options and stock prices depend on what?

Answer 4

the same underlying source of uncertainty

Question 5

what is achieved by forming a portfolio of stocks and options that eliminate source of uncertainty?

Answer 5

portfolio is riskless and earns risk free r§ate of return

Question 6

what are the seven assumptions that the black schoels model makes?

Answer 6

• stock prices follow log normal distribution
• interest and volatility are constant
• no tax/transaction costs
• no dividends
• EU options
• continuous time
• risk neutral pricing

Question 7

what does N(d1) and N(d2) stand for?

Answer 7

cumulative normal probability

Question 8

what does the sigma symbol stand for?

Answer 8

annualised standard deviation, volatility

Question 9

what happens to call value when stock price increase in BS model?

Answer 9

call value increase as d1 and d2 approach 1

Question 10

what happens to call value when stock price decreases in BS model?

Answer 10

call value decreases as d1 and d2 approach o

Question 11

what does S x N(d1) tell you?

Answer 11

the expected value of the stock received, because its a positive number

Question 12

what does - Xe^(-r x T) x N(d1) tell you?

Answer 12

the expected value of exercise price paid, because it’s a negative number

Question 13

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Answer 13

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