Explain the disadvantages of the Black-Scholes Model in pricing interest rate options.?

Question

What models might you use to overcome these disadvantages?

Answer 1

The other models used are somewhat more complicated from what I have heard without varying much in the results. Since everyone uses the same models everyone is valuing the options near the same also. Because of this I do not see a disadvantage to the Black-Scholes model.

Answer 2

There is no problem with B&S model for pricing options. But for calculating hedge ratio it may not work many times. It give values less than 1. The it is for valueing options this formula was created not for finding suitable hedges. So OK . If you are interested I have created many option pricing formulas, one or two are available in Google search type 'Options Mathew Cherian'. You won't regret if you learn that in your spare time also. Good luck.
I forgot you asked about Interest rate options. I don't think you can use Black and Scholes to price interest rate options. There is no dividend in interest rates which is a necessary variable for calculating value using BandS. Then interest rate don't depend on some underlying asset except may be there is a correlation but calculating the P1, P2 etc; without these things are difficult. Black and Scholes as I know is purely for stocks. Interest rate options are priced by figuring out the change in bond price to change in interest rate. Then portfolios are insulated using duration.

Answer 3

A requirement of the model is that input estimates are required, either in the "full" model or the "WallMart" model. This is neither an advantage nor disadvantage, but the output will greatly depend on the accuracy of yor estimates. Remember!! GIGO (garbage in, garbage out).

Answer 4

i've always been told that this model is brilliant. they won the Nobel Prize in 1973 for the work.