This paper analyzes the Black-Scholes (BS) option valuation model using options contracts on ten Indian Stocks. The option prices provided by the BS models are compared to the market prices of the options to gauge the pricing accuracy, money biasness, maturity biasness, and call vs. put biasness of the BS option pricing model. The study found that the BS model misprices options considerably. In most cases, pricing error is negative on an average, and is significantly different from zero, thereby indicating underpricing in many cases. Underpricing reflects the fact that the early exercise feature of the American options is not being accounted for and appears to be overlooked by the BS model. Mispricing worsens with both increased moneyness and increased volatility of the underlying stocks. Further, short-term options are often underpriced and long-term options are mostly overpriced. If the BS model overprices (underprices) low priced options, then it underprices (overprices) high priced options on the same stock.

There has been a tremendous increase in the awareness and activities of derivative securities in the Indian Capital Market in recent years. Trading and pricing of stock option have occupied important place in derivative market. Numerous pricing models have been created and studied. The Black-Scholes (BS) model is the most widely used model and it provides a closed form analytical expression for valuation of European-style options. It has to be borne in mind that the Black-Scholes model is an option valuation model not a theorem. There are always limitations with any such model when applied outside of a theoretical framework with specific assumptions. When the assumptions of the model are relaxed, it may be possible to discern exactly how much discrepancy the model introduces relative to real-life prices and values.“An option pricing model is no more than a tool used by traders for understanding the volatility environment and for pricing illiquid securities consistently with the market prices of actively traded securities. If traders stopped using Black-Scholes and switched to another plausible model—the prices quoted in the market would not change appreciably”.

Although research results show that the BS model does outperform other option pricing models except in the case of deep-in-the-money and deep-out-of-money, the fact that real data often violate most of the model’s assumptions brings it under suspicions. Violations may be found in the following situations: (i) Instead of random walk descriptions, fractal may be a better hypothesis for the market movement. The researchers have rejected the assumption of constant variance of stocks; (ii) in fact, American option dominates the real markets.

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