Formulated in 1973 by Fischer Black and Myron Scholes, and subsequently developed by Robert Merton, the Black-Scholes model has become standard usage for analysts valuing options or synthetic warrants. It is the benchmark against which all other option pricing models are compared.
Whether or not you believe it provides good answers is another matter, but it would be wrong to ignore it even if you doubt its efficacy: if everyone else is using it to predict prices, it will to some extent be self-fulfilling.
It is the mother and father of option pricing techniques, widely used to calculate ‘fair value’ prices in many forms of derivative markets – not just the European-style call options for which it was first created.
Before placing absolute faith in the model, however, it is best to remember that this is a theoretical model which is based on a range of assumptions to simplify matters. The principal assumptions are:
These basic formulae were never intended to work as catch-alls for all forms of derivatives and option-like instruments, and sure enough, the key assumptions are often violated by covered warrants. So the formula has moved on. There have been a number of adaptations, extensions, and developments of the basic Black-Scholes model over the years.
Don’t complain when covered warrant issuers’ determination of fair value differs from the results gleaned from the basic Black-Scholes formulae. They will probably be using subtly different models, and perhaps taking other factors into account, such as their listing, hedging and financing costs.
A better approach is to regard the Black-Scholes results as an approximation and to use them to gauge whether market prices are in the same realm. If not, then some further investigation might be merited.Recommend Reading