A:

Two of the more common equity derivative pricing models are the Black-Scholes model and the binomial option pricing model. Equity derivatives are also known as options. The pricing of options is of vital importance to those who trade them.

## Black-Scholes Model

The Black-Scholes model is the most common model used in the analysis and pricing of equity derivatives. The model was first published in 1973. Fischer Black and Myron Scholes received the 1997 Nobel prize in economics for their work on this model.

The inputs for the Black-Scholes model are the current price of the underlying stock, the option strike price, the time until the expiration of the option, the risk-free interest rate and the implied volatility of the underlying stock.

While the Black-Scholes model is well-known in the finance community, it does have some limitations in the assumptions it makes, such as only being applicable to European-style options and assuming normal distributions of the underlying returns. European options can only be exercised on their expiration dates, while American options can be exercised up until expiration. American options are used for individual stocks, while European options are only used on index options. Other pricing models have been created that can handle American options.

## Binomial Option Pricing Model

The second most common model is the binomial pricing model. This model uses an iterative function to determine the valuation of the option at different nodes, or points in time, between the date of valuation and the expiration date.

This model takes a risk-neutral approach to option pricing by assuming the price of the underlying stock can only go up or down at each node in the process. The binomial model has distinct advantages over the Black-Scholes model; it can be used for American options and is much simpler to calculate.

RELATED FAQS
1. ### When holding an option through expiration date, are you automatically paid any profits, ...

Holding an option through the expiration date without selling does not automatically guarantee you profits, but it might ... Read Answer >>
2. ### How is the price of a derivative determined?

Learn how different types of derivatives are priced, including how futures contracts are valued and the Black-Scholes option ... Read Answer >>
3. ### Can an option be exercised on the expiration date?

The use of options has increased dramatically over the years as a way to profit from or hedge against the volatile movements ... Read Answer >>
4. ### What is index option trading and how does it work?

Learn about stock index options, including differences between single stock options and index options, and understand different ... Read Answer >>
5. ### Do options make more sense during bull or bear markets?

Understand how options may be used in both bullish and bearish markets, and learn the basics of options pricing and certain ... Read Answer >>
Related Articles

### Breaking Down The Binomial Model To Value An Option

Find out how to carve your way into this valuation model niche.

### Circumvent Limitations of Black-Scholes Model

Mathematical or quantitative model-based trading continues to gain momentum, despite major failures like the financial crisis of 2008-09, which was attributed to the flawed use of trading models. ...
3. Investing

### The Volatility Surface Explained

Learn about stock options and the "volatility surface," and discover why it is an important concept in stock options pricing and trading.
4. Investing

### Examples To Understand The Binomial Option Pricing Model

Binomial option pricing model, based on risk neutral valuation, offers a unique alternative to Black-Scholes. Here are detailed examples with calculations using Binomial model and explanation ...
5. Investing

### Using Decision Trees In Finance

These decision-making tools play an integral role in corporate finance and economic forecasting.

### Understanding How Dividends Affect Option Prices

Learn how the distribution of dividends on stocks impacts the price of call and put options, and understand how the ex-dividend date affects options.

### How & Why Interest Rates Affect Options

The Fed is expected to change interest rates soon. We explain how a change in interest rates impacts option valuations.
RELATED TERMS
1. ### Binomial Option Pricing Model

An options valuation method developed by Cox, et al, in 1979. ...
2. ### Option Pricing Theory

Any model- or theory-based approach for calculating the fair ...
3. ### Black's Model

A variation of the popular Black-Scholes options pricing model ...
4. ### Robert C. Merton

An American economist who won the 1997 Nobel Memorial Prize in ...
5. ### Bjerksund-Stensland Model

A closed-form option pricing model used to calculate the price ...
6. ### Myron S. Scholes

An American economist and winner of the 1997 Nobel Prize in Economics ...
Hot Definitions
1. ### Turkey

Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
2. ### Maintenance Margin

The minimum amount of equity that must be maintained in a margin account. In the context of the NYSE and FINRA, after an ...
3. ### Salvage Value

The estimated value that an asset will realize upon its sale at the end of its useful life. The value is used in accounting ...
4. ### Cryptocurrency

A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
5. ### Promissory Note

A financial instrument that contains a written promise by one party to pay another party a definite sum of money either on ...
6. ### SEC Form 13F

A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...