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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.

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