disadvantages of black scholes and binomial tree

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Permalink Reply by preetam chandra on September 19, 2009 at 11:17am

1. Black scholes easy to calculate. But limitation is that it prices only European options
2. Binomial tree. A bit lengthy procedure. But it can price both European and American Options. Another
benefit is that if you increase the periods, it gives better Option Price.

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Permalink Reply by selva on December 15, 2009 at 2:22pm

One disadvantage regarding the Black scholes is that it assumes the volatility to be constant.

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Permalink Reply by Anurag Singh Chauhan on January 7, 2010 at 4:57pm

Binomial Model: This model is a basic valuation of option from scratch (i.e. piece by piece valuation in layman language), and hence is very simple, easy to understand, additive. Moreover, being additive from scratch, this model can technically value any type of options, on any asset (with cost of carry or with dividends attached), with early excercise (american option) or fixed maturity (EU options) , or with other sort of exotic options like knock-in/out barriers. So, in short, BM being a simple models, can be a long process however can value many type of options.

BSM Option Pricing Model: This model summarizes the option valuation in the form of complex equation (that is derived using differential equation - that you need not bother). It is a sort of 'implied' valuation of options using other five factors which are known. Hence this is a complex model, and understanding from where the valuation comes in not as easy and visible as in the case of BM. Further, it assumes certain idealistic assumptions that dont hold true (like constant volatility assumptions). To over come such limitations, even further advanced and complex models are devised.
As mentioned above, BSM model values only European Options (as it cant accomodate the provisions of EARLY EXCERCISE as in the case of American Options). And, if the underlying asset has some Net Benefit (like dividend) or net cost of carry attached with it, then also BSM model deviates from the true valuation of such options. So in short, BSM being a complex implied valuation methodology is quick however can value only limited types of options and that too within constrained assumptions.


I believe the question asked is either a basic one that you can easily 'google' out, or may be you would like to ask in more details on exactly which context you want to know the difference between the two.

~ anurag

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