Black-Scholes Model Definition – The Black-Scholes Model is the prevailing mathematical formula used to price currency options in the market with a fixed, European style, expiration date. The model generates prices based on a set of ideal assumptions related to volatility, standard normal distribution, and probability densities. The primary drivers of the pricing model are current forex price, intrinsic value, time to expiration, and volatility. The theory behind the model contends that a currency and its call option are comparable investments. The movement of price in the currency will also be reflected in the movement of the price of the option, but not necessarily by the same amplitude. The Black-Scholes model does not mimic reality perfectly due to the simplicity required in its assumptions. It is widely employed as a useful approximation, but avoidance of risk requires an understanding its limitations for proper application. Fischer Black and Myron Scholes first articulated their pricing model in 1973. The basic insight of Black-Scholes is that the option is implicitly priced if the currency is traded. Merton and Scholes received the 1997 Nobel Prize in Economics for their work. However, critics have suggested that the model merely recast many other pricing models that had been used for years.
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