Removing the 'Black Box' from the Black-Scholes Option Pricing Model

42 Pages Posted: 3 Jan 2012 Last revised: 5 Jan 2012

Date Written: January 3, 2012

Abstract

In The Ascent of Money (2008), the Harvard financial historian Niall Ferguson refers to the Black-Scholes option pricing model 'as a black box' which is beyond comprehension of anyone except the mathematically astute and leaves most investors baffled. In this paper, we develop a heuristic proof of Black-Scholes as an aid to learning, discovery and problem solving. From a deterministic model, the basic structure of Black-Scholes is identified. Thereafter, the generalized form of Black-Scholes is deduced and various underlying components examined with particular emphasis on a conceptual understanding of the symbols N(d1) and N(d2). The methodology relies heavily on intuition and transparency with the more rigorous mathematics relegated to the appendices.

Keywords: Black-Scholes, black box, heuristic proof, intuition, transparency

JEL Classification: G10, G13

Suggested Citation

Maberly, Edwin D. and Pierce, Raylene M., Removing the 'Black Box' from the Black-Scholes Option Pricing Model (January 3, 2012). Available at SSRN: https://ssrn.com/abstract=1978649 or http://dx.doi.org/10.2139/ssrn.1978649

Edwin D. Maberly (Contact Author)

Monash University ( email )

Clayton Campus
Wellington Road
Clayton, VIC 3800
Australia
61399055178 (Phone)

Raylene M. Pierce

Deakin University ( email )

75 Pigdons Road
Victoria, Victoria 3216
Australia

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