Question

Black Shoals Option pricing model. The BSM model is a powerful tool to find the value of options and has allowed for the advancement and the trading of options every day and around the world. Of course, with every advance in modern financial theory, there are some that have doubts about the outputs of certain models.

Are the mathematics behind the BSM (Black Scholes) model valid for real-life trading? Why, or Why not.

Answer 1

One of the important mathematics assumptions in BSM model is Returns of underlying are Normally Distributed.

For Real-life, stock returns are not exactly normally distributed. Thus, the primary mathematical assumption for BSM Model is not valid for real-life

Apart from this, BSM assumes no transaction costs and taxes which isn't valid for real-life trading. Also, it has unrealistic assumption that stocks do not pay any dividends.

Also, other BSM assumptions are unrealistic:

BSM assumes efficient markets

Volatility of stock is known and constant (In real-life trading, Volatily of stock cannot be constant nor known in advance)

Thus, mathematics behind BSM model are invalid for real-life trading.

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