Saturday, 30 November 2019

Unit 6: Valuation and Pricing of Options

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                           Unit 6: Valuation and Pricing of Options   






The value of an option is determined by its chance to be exercised with profit on the expiry day.
This consists of two parts: the real value and the time value.
The real value is the value that is possible to ‘touch’.
Conversely the time value is the value of the possibility that good news will occur during the time to maturity in order for an option to have a real value on the expiry day.
Put-call is nothing but a relationship that must exist between the prices of European put and call options having same underlying assets, strike price and expiration date.
The price of an option contract is that amount which is paid by the option buyer to the option seller.
This is otherwise, known as option premium.
The different factors or determinants which effect option prices are Current Stock Price, Exercise Price, Volatility, Risk free Interest Rates, Cash Dividends and Time to Expiration.
•   To better understand the significance and option pricing techniques, we have to go through two important models of option valuation like Black-Scholes model and Binomial model.
This unit also discusses at large the Put-Call parity under the ‘with dividend’ and ‘no dividend’ model.
Put-call parity is a classic application of arbitrage-based pricing – it does not instruct us on how to price either put or call options, but it gives us an iron law linking the two prices.
The put-call parity states that the difference in price between a call-option and a putoption with the same terms should equal the price of the underlying asset less the present discounted value of the exercise price.
In finance, the binomial options pricing model provides a generalisable numerical method for the valuation of options.
The binomial model was first proposed by Cox, Ross and Rubinstein (1979).
The Black-Scholes model, often simply called Black-Scholes, is a model of the varying price over time of financial instruments, and in particular stock options.
American-style option: An American-style option is an option that may be exercised at any time during the life of the option.
Intrinsic value: The intrinsic value of a call option is that amount by which stock price exceeds the strike price, whenever the option is in-the-money.
Option price: The price of an option contract is that amount which is paid by the option buyer to the option seller.
Pari options: Options where the strike price and stock price corresponds are ‘at-the-money’ and are called pari options.
Put-call parity: Put-call parity is a classic application of arbitrage-based pricing – it does not instruct us on how to price either put or call options, but it gives us an iron law linking the two prices.
Real Value: The real value is the value that is possible to ‘touch’.
Time Value: The time value is the value of the possibility that good news will occur during the time to maturity in order for an option to have a real value on the expiry day.
Volatility: The volatility of a stock price represents the uncertainty attached to its future movement.
Financial Derivatives     
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