Finance - Turning Finance Into Science - Risk Management And The Black-Scholes Options Pricing Model(1).pdf

Turning Finance into Science:
Risk Management and the Black-
Scholes Options Pricing Model
Albert Kim
Mary Frauley
Writing for the Sciences
English ENG­LBE 09
Monday, May 1st 2000
Recently, the people behind the famed Black- Scholes Options
Pricing Model received the Nobel Prize in Economics. Scientific
American delves into this formula that has its share of praise,
and criticism
A New Breed of $cience
In recent years, a new discipline called financial engineering has emerged
in order to attempt to understand finance using a scientific approach.
Mathematicians, physicists and traders work together in this discipline in order
to incorporate the use of advanced mathematics with everyday finance (Stix,
1998).
Although financial engineering deals with many aspects of finance, the
main application of this discipline is risk management within the stock market.
Regardless of what type of stock market transaction one performs, risk is
always present. However, it is the management of this risk that is studied by
these “financial engineers”. People need a fast and reliable way to calculate and
control the risk involved in all their stock trading.
This is where the Black- Scholes Option Pricing es in. This
ideas behind this formula, created by Prof. Robert C. Merton, Prof. Myron S.
Scholes and the late Fisher Black, has been described by one economist as “the
most essful theory not only in finance but in all of economics.”(Stix, 1998)
Options
2
The functioning of the Black- Scholes Model is based on the use of stock
options. Stock options are a form of financial derivative (an item that is not a
stock in itself, but is an offshoot of one). It consists of a contract that gives
one the right, but not the obligation , to buy stocks later at a fixed price (known
as the exercise or strike price). The exercise price does not change, regardless
of all changes in the stock’s value. These options are purchased at a fee
known as the pr