About the cost of portfolio financing in Black-Scholes call option valuation

Cokki Versluis

Applied Financial Economics Letters, 2006, vol. 2, issue 2, pages 95-97

Abstract: The theory of Black and Scholes is the basis for all contemporary financial option valuation methods. The theory is based on a portfolio consisting of stocks and options on that stock. The composition of the portfolio is renewed after a short time interval. The Black-Scholes method for valuing European call options ignores the cost of portfolio renewal. This study demonstrates that ignoring this cost may lead to an error. The relative error can be very large, especially in the case of out-of-the-money options, where the drift of the price process of the underlying asset substantially deviates from a risk-free drift.

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