The authors derive a theoretical framework for valuing options using hedged portfolios and no arbitrage principles. Their model shows option values can be determined without estimating expected stock returns, while extending the same logic to corporate bonds, warrants, and default risk.
The Pricing of Options and Corporate Liabilities
Myron Scholes, Fischer Black
Research
19 Pages
Key Takeaways
Seven Core Assumptions: The valuation formula relies on 7 idealized market conditions, including constant interest rates, no dividends, no transaction costs, and unrestricted short selling.
Options Amplify Volatility: Equation 14 shows option price elasticity is always greater than 1, meaning options are more volatile than their underlying stocks.
Debt As Options: In a 10 year bond example, equity behaves like a call option on corporate assets, allowing default risk to be incorporated into bond valuation.
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