Black-Scholes option model assumptions

Let us consider then the key assumptions that form part of the economy of, for example, the Black-Scholes option pricing model. 

The key assumption in the derivation of the Black-Scholes option pricing model is that the asset price follows a lognormal distribution, so that if we assume the asset price is P we write... 

The price behavior of financial instruments. One of the key assumptions of option pricing models such as Black-Scholes (B-S), which is discussed below, is that asset prices follow a lognormal distribution— that is, the logarithms of the prices show a normal distribution. This characterization is not strictly accurate prices are not lognormally distributed. Asset returns, however, are. Returns are defined by formula (8.8). 

Most option pricing models use one of two methodologies, both of which are based on essentially identical assumptions. The first method, used in the Black-Scholes model, resolves the asset-price model s partial differential equation corresponding to the expected payoff of the option. The second is the martingale method, first introduced in Harrison and Kreps (1979) and Harrison and Pliska (1981). This derives the price of an asset at time 0 from its discounted expected future payoffs assuming risk-neutral probability. A third methodology assumes lognormal distribution of asset returns but follows the two-step binomial process described in chapter 11. 

The introduction of the Black-Scholes model paved the way for the rapid development of options as liquid tradable products. B-S is widely used today to price options and other derivatives. Nevertheless, academics have pointed out several weaknesses related to the main assumptions on which it is based. The major criticisms involve the following ... 

A number of option-pricing models exist. Market participants often use variations on these models that they developed themselves or that were developed by their firms. The best-known of the pricing models is probably the Black-Scholes, whose fundamental principle is that a synthetic option can be created and valued by taking a position in the underlying asset and borrowing or lending funds in the market at the risk-free rate of interest. Although Black-Scholes is the basis for many other option models and is still used widely in the market, it is not necessarily appropriate for some interest rate instruments. Fabozzi (1997), for instance, states that the Black-Scholes model s assumptions make it unsuitable for certain bond options. As a result a number of alternatives have been developed to analyze callable bonds. 

The theory of options was developed in the assumption of market equilibrium. The first option pricing model was proposed by Black and Scholes (1973) and then by Merton (1973), in which they did not consider dividend payments. Authors as Schwartz (1975) include dividend payments into valuation model and also consider the possibility of exercising the option before the maturity... 

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