| Summary: | In order to further develop the derivative markets, the Chinese government has decided to launch stock options as soon as possible. The Black-Scholes formula has been the most commonly used option pricing model today. But is the Black-Scholes model an appropriate tool for pricing of Chinese stock option?
If the Black-Sholes model is perfect, implied volatilities should be exactly the same for options on the same underlying asset with different strike prices. This project, however, discovered that the pattern of the implied volatility across different exercise prices is negatively skewed, that is, the volatility decreases as the strike price increases, indicating that the Black-Sholes model is flawed to value Chinese stock options.
This study also founds that the volatility skew arises from the unrealistic assumptions of the Black-Sholes model, such as normally-distributed return, risk-neutral investors and no-arbitrage opportunities. Additionally, China's unique business environment also weakens the reliability of the Black-Sholes model.
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