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The model has some limiting assumptions relating to the underlying nature of the cash flows and our ability to adjust our exposure to risks as time passes.
On the cash flows, we assume that the volatility of the cash flows is constant. If the cash flows has a volatility of 25%, what does this means…?
In this model, can we adjust the risk exposure from time to time? Or should we assume that the risk exposure is constant too…?
Thanks…
Have you actually watched the free lecture on option pricing?
The volatility is the extent to which the cash flows vary, and is measured by the standard deviation.
The model enables us to calculate a price for an option – we cannot change the level of risk of the underlying flows! I think what you are referring to is a delta hedge – using options as a way of hedging the risk of movements in the share price. We can (and in practice will) adjust the delta hedge as the variables in the formula change, as I do explain in the lecture.
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