Black-Scholes Method for Pricing Research Paper Starter

Black-Scholes Method for Pricing

(Research Starters)

Hedging is an increasingly popular practice, offering investors an opportunity to mitigate potential losses by counterbalancing with futures contracts. However, the predictability of the potential returns on such contracts has long proven nebulous, due to the uncertainty surrounding long-term worth and value. In 1973, however, financial analyst Fischer Black and finance professor Myron Scholes created a model whereby much of the uncertainty surrounding the potential return on hedging investments may be mitigated. This paper will examine the "Black-Scholes" method for pricing, its fundamentals and its applications in the 21st century economy.

Keywords Call Options Profit; Derivative; Hedge Fund; Hedging; In the Money Call; Option; Out of the Money Call

Overview

Benjamin Franklin once stated, "I conceive that the great part of the miseries of mankind is brought upon them by false estimates that they have made of the value of things" (http://www.valuequotes.net/). Indeed, one of the most challenging aspects of life is assigning not just worth, but also value to a given subject.

Value is one of the most vexing of concepts in the world of international commerce and investment. Affixing a price to a given product, good or service is a relatively simple action based on current conditions surrounding the production of that item. Value, however, is more long-term; subject to the conditions not just of the present but of the short-term and longer-term future. Determining the value of an investment may, therefore, assist in generating a higher yield to the investor.

In the 21st century global economy, there exists a myriad of markets in which entrepreneurs may invest their assets in the hope of a return on that investment. Most investors, fearful of losing their money in a single market that experiences sudden collapse, diversify their portfolios across a broad spectrum of markets. Others, also mindful of the risks involved with investments (particularly in a volatile economy), seek to "insure" themselves from loss by hedging on their investments.

Hedging is an increasingly popular practice, offering investors an opportunity to mitigate potential losses by counterbalancing with futures contracts. However, the predictability of the potential returns on such contracts has long proven nebulous, due to the uncertainty surrounding long-term worth and value. In 1973, however, financial analyst Fischer Black and finance professor Myron Scholes created a model whereby much of the uncertainty surrounding the potential return on hedging investments may be mitigated. This paper will examine the "Black-Scholes" method for pricing, its fundamentals and its applications in the 21st century economy.

Further Insights

A Brief Introduction to Hedging

In order to understand the applicability of the Black-Scholes method, one must first understand the practice of hedging. This practice is seen by many as a recent development in the world of finance, although scholars trace its origins as far back as the days of Aristotle, who told a tale of Thales, the philosopher. Thales haggled with the owners of olive press equipment to gain exclusive rights to use the presses during the harvest later that year. In order to gain this access, he put forth a considerable investment against the industry, which solidified for him a significant profit on his wager (Rappeport, 2007).

In 1949, journalist and academic Alfred Winslow Jones decided to abandon journalism and take up finance, forming A.W. Jones and Company with three friends and investing $100,000 of his own money. The fund would employ a wide mix of short- and long-term positions with considerable incentives for participating investors. One year later, Jones's fund (to which Fortune magazine's Carol Loomis would refer two decades later as the first "hedge fund") earned more than 17 percent than in the previous year, and over the following decade would outperform every other mutual fund by more than 87 percent (Rappeport, 2007).

Today, hedge funds comprise an estimated $1 trillion industry, using a wide range of tactics that creates considerable diversity among funds (McWhinney, 2009). The practice is often given the more familiar moniker, "insurance." Indeed, hedging involves an investor's understanding the risks associated with a long-term investment and, in order to mitigate any unforeseen downturns in the performance of the company in question, taking out short-term, high-yield investments in order to offset any negative performance.

Derivatives

Central to the practice of hedging are derivatives, which are simply contracts between two or more parties. The value of derivatives depends on conditions surrounding the parties' underlying assets (such as stocks, bonds and currencies). For the purposes of hedging, derivatives are manifested in two forms. The first is the futures contract. Investors and companies alike may use these arrangements to ensure that their prices are stable. A manufacturer, for example, may purchase a futures contract on the price of oil, which is absolutely essential to the operation of the company's machinery. This contract will set a price at which the oil is purchased. When political instability, terrorist incidents or simply high demand send the price of oil skyward, that company's futures contract will keep its oil prices stable. In fact, the company may come out ahead, saving considerably on expenses. Of course, during times of economic and political stability, or even during spring and non-holiday summer months, when the price of oil seeps below the set price of the futures contract, the company is still obligated to pay for oil at the set price, which means that it may have been better off not entering such a hedge arrangement ("A beginner's guide," 2009).

The second derivative in hedging is the option, which is a derivative contract in which an individual agrees to either buy (put) or sell (call) stock in a company within a fixed, short period of time and at a set price (known as the "strike price"). If the stock in question falls below strike price, the holder of the option will still see a profit from the call, gains that may be used to offset any short-term losses associated with long-term holdings.

The most challenging part of hedging has long been setting a price for options. Far too many variables exist in the marketplace, particularly in one as globally expansive and diverse as the 21st century economy, making price setting for options a daunting task. Doing so is, in essence, placing a long-term value on a given contract, but basing that contract on a large collection of potentially volatile factors

In 1973, however, Fischer Black and Myron Scholes crafted a theoretical framework that for many answered this extremely vexing problem using mathematical formulae and even physics equations (Bookstaber, 2003). In introducing the theory (which contemporary Robert Merton later coined the "Black-Scholes Method for Pricing") in their paper, "The Pricing of Options and Corporate Liabilities," Black and Scholes laid a whole new foundation for finance and business. Merton would expand this theory and help apply...

(The entire section is 3172 words.)