The Problem of Volatility in the Black-Scholes Model
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Abstract
Since it was developed in 1973, the Black-Scholes model (BSM) has been the gold standard for option pricing. While more sophisticated and arguably more accurate models have been created since then, the BSM has been praised for its simplicity and ease-of-use. It achieves this simplicity due to a total of six assumptions it makes about the option in question, and while many of these assumptions are not accurate for the real world, they theoretically do not affect the accuracy of the formula too much. One assumption concerns the constant (as opposed to variable) nature of the volatility of the stock price. But since volatility is not able to be directly observed, it must be guessed at by using historical data. The goal of my research is to determine the best time frame of historical data to use to calculate volatility.