Business, Legal & Accounting Glossary
Used for pricing options on non-dividend paying stocks.
A challenge in pricing options on commodities is non-randomness in the evolution of many commodity prices.
For example, the spot price of an agricultural product will generally rise prior to a harvest and fall following the harvest. Natural gas tends to be more expensive during the Winter months than the Summer months. Because of such non-randomness, many spot commodity prices cannot be modelled with a geometric Brownian motion, and the Black-Scholes (1973) or Merton (1973) models for options on stocks do not apply. In 1976, Fischer Black published a paper addressing this problem. His solution was to model forward prices as opposed to spot prices.
Forward prices do not exhibit the same non-randomness as spot prices. Consider a forward price for delivery shortly after a harvest of an agricultural product. Prior to the harvest, the spot price may be high, reflecting depleted supplies of the product, but the forward price will not be high. Because it is for delivery after the harvest, it will be low in anticipation of a drop in prices following the harvest. While it is not reasonable to model the spot price with a Brownian motion, it may be reasonable to model the forward price with one. Black’s (1976) option pricing formula reflects this solution, modelling a forward price as an underlier in place of a spot price.
The model is widely used for modelling European options on physical commodities, forwards or futures. It is also used for pricing interest rate caps and floors. The model is popularly known as Black ’76 or simply Black’s model.
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This glossary post was last updated: 22nd November, 2021 | 8 Views.