Merits and Shortcomings of the Black-Scholes-Merton (BSM) Approach: An Analysis of the Role of Volatility

Abstract

The historical background of option pricing dates back to 1900; before the Black-Scholes-Merton approach (BSM) was finalised, Louis Bachelier introduced the method of modelling option prices that was later extended by Sharpe and Lintner up until 1965 (Merton, 1973). With these foundations at hand, Black, Scholes and Merton finalised the model in 1973. They constructed a model to determine the equilibrium value of an option by knowing the current price of the stock, the option striking price, the shortterm interest rate (risk free), time to expiration (maturity), and the volatility of the return on the stock (Black and Scholes, 1971). The aim of this paper is to assess its economic and empirical validity as opposed to its shortcomings and limitations. The paper is structured as follows. The first section describes the main assumptions of the BSM model. The second section provides an overview of the main merits and weaknesses of the approach, followed by a description of the contingent applications of the BSM in the next section. The final section is aimed at reminding the reader of the main points of the paper and provides constructive conclusions.