Simple Heuristic Approach To Introduction Of The Black-Scholes Model

Abstract

A heuristic approach to explaining of the Black-Scholes option pricing model in undergraduate classes is described. The approach draws upon the method of protocol analysis to encourage students to `think aloud' so that their mental models can be surfaced. It also relies upon extensive visualizations to communicate relationships that are otherwise inaccessible at the average student's level of mathematical sophistication. This paper presents visual illustration of the changes in the probability measures with concrete examples breaking the option premium into four different components. The relationship between changes in variables and those components are graphically and algebraically illustrated.