Criticism of the Black-Scholes Model: But Why is It Still Used?: (The Answer is Simpler than the Formula)

Abstract

The Black Scholes Model (BSM) is one of the most important concepts in modern financial theory both in terms of approach and applicability. The BSM is considered the standard model for valuing options; a model of price variation over time of financial instruments such as stocks that can, among other things, be used to determine the price of a European call option. However, while the formula has been subject to repeated criticism for its shortcomings, it is still in widespread use. This paper provides a brief overview of BSM, its foundational underpinnings, as well as discusses these shortcomings vis-à-vis alternative models. This paper was originally written as a part of the course 'Derivatives & Capital Markets' in 2004, during my time at New York University under exam conditions. This present paper is an updated version with references.

Keywords: Black-Scholes-Merton, BSM, stochastic volatility, jump diffusion, Nassim Taleb, levy process, binomial tree, normal distribution, Gaussian, Brownian Motion

JEL Classification: C10, C60, F30, G30