If your firm has gotten used to using the Black-Scholes Options Price Model (BSOPM) when valuing options and other derivatives, you may want to rethink your practice. The reason? The BSOPM may not be entirely accurate when pricing derivatives that are other than “plain vanilla,” says Anthony Alfonso, president of BDO Valuation Advisors in Los Angeles. Non-vanilla options are those with “dynamic features,” such as variable strike prices.

This isn’t just Alfonso’s opinion. In a November presentation, “SEC Staff Review of Common Financial Reporting Issues Facing Smaller Issuers,” the SEC states, “Black-Scholes may not be appropriate in many situations given complex features and terms of conversion option (e.g., combined embedded derivatives).”

In addition, Alfonso has seen an increase in comment letters from the SEC regarding different companies’ use of BSOPM. In most, the Commission questions a company’s application of the model to value a derivative containing one or more variables, as it fails to account for the value the variable(s) add(s) to the instrument, Alfonso says.

Two other options pricing models tend to work more effectively when valuing options with variable parameters: binomial lattice and Monte Carlo simulation. “Where Black-Scholes is just a formula, the binomial lattice is more open-form,” Alfonso says. “It can account for variable features.” According to Investopedia, the lattice model “involves the construction of a binomial tree to show the different paths that the underlying asset may take over the option’s life. A lattice model can take into account expected changes in various parameters, such as volatility, over the life of the options, providing more accurate estimates of option prices than the Black-Scholes model.” The Black-Scholes model, on the other hand, assumes the same level of volatility over the life of the option.

In contrast, Monte Carlo simulation is “an analytical technique in which a large number of simulations are run using random quantities for uncertain variables, and looking at the distribution of results (in order) to infer which values are most likely,” according to InvestorWords.com.

So, say a warrant becomes immediately exercisable if the underlying stock price increases more than 20 percent over the next 18 months. A Monte Carlo simulation can provide an idea of just how likely it is that this will happen, and this then can be factored into the option’s value.

It’s difficult to say that one type of option always should be valued according to BSOPM, while another always is better suited to Monte Carlo simulations. “It depends on how they’re written,” Alfonso says.

Most companies stick with the BSOPM, whether or not it’s the most appropriate, simply because that’s what they’ve done and they’re familiar with the model, Alfonso notes. However, treasurers and CFOs should be aware that the SEC is taking a closer look at its application, Alfonso says. If the SEC questions a company’s use of Black-Scholes, assembling the information needed to respond can take a week or two, particularly if the company has to consult with outside advisors. That can cause trouble. “You have to justify what you’ve done, and if you can’t, the SEC can make you restate,” he says. ###