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    Options - Chapter 3

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    Mandy Randi
    The document discusses various types of options and their terminology. It covers the key determinants of option value according to financial models like Black-Scholes, including the underlying asset price, volatility, time to expiration, interest rates, and exercise price. The Black-Scholes model and binomial option pricing model are introduced for calculating theoretical option values based on these factors. Assumptions and applications of the models are also summarized.

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    Options - Chapter 3

    Uploaded by

    Mandy Randi
    41 views16 pages
    The document discusses various types of options and their terminology. It covers the key determinants of option value according to financial models like Black-Scholes, including the underlying asset price, volatility, time to expiration, interest rates, and exercise price. The Black-Scholes model and binomial option pricing model are introduced for calculating theoretical option values based on these factors. Assumptions and applications of the models are also summarized.

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    The document discusses various types of options and their terminology. It covers the key determinants of option value according to financial models like Black-Scholes, including the underlying asset price, volatility, time to expiration, interest rates, and exercise price. The Black-Scholes model and binomial option pricing model are introduced for calculating theoretical option values based on these factors. Assumptions and applications of the models are also summarized.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    41 views16 pages

    Options - Chapter 3

    Uploaded by

    Mandy Randi
    The document discusses various types of options and their terminology. It covers the key determinants of option value according to financial models like Black-Scholes, including the underlying asset price, volatility, time to expiration, interest rates, and exercise price. The Black-Scholes model and binomial option pricing model are introduced for calculating theoretical option values based on these factors. Assumptions and applications of the models are also summarized.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 16

    OPTIONS

    CHAPTER-3
    • Meaning of Options
    Options are financial derivatives that give
    buyers the right, but not the obligation, to buy
    or sell an underlying asset at an agreed-upon
    price and date.

    Basic Types
    1. Call
    2. Put
    3. American Options
    4. European Options
    5. Exchange Traded Options
    6. Over The Counter Options
    7. Employee Stock Options
    8. Cash Settled Options
    9. Stock Options
    10. Index Options
    11. Asian Options
    12. Uncovered options and Covered options
    13. Covered Options
    14. Caps, Floors and Collar
    15. Exotic Options
    16. Vanilla Option
    17. Basket Options
    18. Regular Options
    Terminologies used in Option Trading

    • Time Value
    • Intrinsic Value
    • At-The-Money (ATM)
    • Out-of-The-Money (OTM)
    • In-The-Money (ITM)
    • Expiration date
    • Exercise
    • Strike Price
    • Short
    • Long
    • Option Premium
    VALUATION OF OPTIONS

    Determinants of Option Value

    • Anticipated cash Payments on the stocks


    • Risk free interest
    • Volatility [or Variance ] in stock
    • Time to expiration
    • Exercise price
    • Current stock price
    PROPERTIES OF OPTION VALUES

    • The minimum value of an option is zero


    • The maximum value of a call option is equal to the value
    of the underlying asset.
    • The total value of an option is the sum of its intrinsic
    value and its time premium.
    Intrinsic Value of Options
    In Call
    • Intrinsic Value = Price of Underlying Asset - Strike Price

    In put
    • Intrinsic Value = Strike Price - Price of Underlying Asset

    Time Value
    • Time Value = Option Premium - Intrinsic Value
    • Option Premium = Intrinsic Value + Time Value
    THE BLACK-SCHOLES OPTIONS PRICING MODEL

    • The Black Scholes model, also known as the Black-Scholes-


    Merton (BSM) model, is a mathematical model for pricing an
    options contract.

    • It is developed by three economists—Fischer Black, Myron


    Scholes and Robert Merton

    • The Model or Formula calculates an theoretical value of an


    option based on 6 variables. These variables are:
    • Whether the option is a call or a put
    • The current underlying stock price
    • The time left until the option's expiration date
    • The strike price of the option
    • The risk-free interest rate
    • The volatility of the stock
    Assumptions

    1. No dividends
    2. European-style
    3. Markets are efficient
    4. No commissions
    5. Interest rates are assumed to be constant
    6. Lognormal distribution
    • C - theoretical option value(Call Premium)
    • S - current stock price
    • N – Cumulative standard Normal distribution
    • E -exercise price written in the option contract
    • e – Exponential term(2.7183)
    • r - risk-free interest rate
    • t - time in years until option expiration
    • σ - is a measure of annual volatility of the underlying stock,
    which is often measured by the standard deviation of
    stock returns.
    • ln = natural logarithm
    Advantages
    • It is relatively easy to understand
    • Use to calculate large number of option prices in short
    time.
    • Standard way to quote prices
    • High accuracy
    BINOMIAL MODEL

    • The binomial option pricing model(BOPM) was first


    proposed by Mr.Cox Rossand Mr.Rubinsten developed in
    1979.
    Assumptions
    • There are only two possible prices for the underlying asset
    on the next day. From this assumption, this model has got
    its name as Binomial option pricing model (Bi means two)
    • There are no market frictions – no transaction cost
    • Market participants enter no counterparty risk
    • Markets are competitive
    • There is no opportunity for arbitrage
    • There is no interest rate uncertainty.
    Advantages of Binomial Option Pricing Model
    • simple to use
    • valuing American options
    • Bermudan options
    • Limitations of Binomial Option Pricing Model - One
    major limitation of binomial option pricing model is its
    slow speed. Computation complexity increases in multi
    period binomial option pricing model.

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