How Does the Black-Scholes Model Relate to Pricing Options on Cryptocurrencies?
The Black-Scholes model provides a theoretical framework for estimating the fair price of European-style options. While originally for traditional finance, it is adapted for crypto options by substituting the underlying asset price and volatility.
Key inputs are the current crypto price, strike price, time to expiration, risk-free rate, and volatility. Its main limitation in crypto is accurately modeling the high, unpredictable volatility and the lack of a true risk-free rate.
Glossar
The Black-Scholes Model
Foundation ⎊ The Black-Scholes model serves as the cornerstone for modern options pricing theory, providing a continuous-time framework for calculating the fair value of derivatives.
Black-Scholes Formula
Derivation ⎊ The Black-Scholes Formula, initially proposed in 1973, provides a theoretical estimate of the price of European-style options, fundamentally altering quantitative finance and risk management practices.
Risk-Free Rate
Rate ⎊ The risk-free rate represents the theoretical return on an investment with zero risk, serving as a critical input in option pricing models to calculate the cost of carrying an asset forward in time, particularly relevant for valuing longer-dated crypto options.
Volatility Skew
Bias ⎊ This term describes the non-symmetrical relationship between implied volatility levels for options with different strike prices, indicating a market bias toward expecting larger moves in one direction.