Topic 3: Option pricing

L6-L8

What is an option?

Gives the holder the right but not obligation to buy or sell a given quantity of an asset in the future at prices agreed upon today

What are the two types of options

Put and Call

What is a Call Option

An option to buy a specific asset

What is a put option

An option to sell a specific asset

What is the excersise or strike price

The pre specified price at which an asset can be purchased or sold

What is E

The excersise or strike price

What is the premium

The cost, price, value of the option

What is Vc or Vp

The premium

What is the spot price?

Cash market price of the underlying asset

What is Vs

The spot price

What is the expiration or maturity date?

On or before whic han option can be excessed

What is an european option

Excersisable only on expiry date

What is an american option

Excersisable at any time up to expiry date

What is a At the money(ATM) option?

Excersise price is the same as the spot price of the underlying asset

What is the equation of ATM

E = Vs

What is an in-the-money(ITM) Option?

An option that would be profitable exclusong the cost of the premium

What is an out-of-the money(OTM) option?

An option that would not be profitable, excluding the cost of the premium

What is the value of call at expiry equation

Vc = Max (Vs − E, 0)

How to calculate the value of a put option relating to expiry date?

The expiry date value of a put option is the greater of the excersise price minus the share price or nothing

What is the intrinsic value?

The financial gain if the option is exercised immediately

Why does the time value of an option exist

Because the price of the underlying asset can potentially move further into the money between now and the expiry date.

The greater the volatility of the underlying share…

The greater the value of the option

What does the binomial model cosider

Two possible changes in the next periods share price

What is the basic idea of the binomial model

Set up an option equivalent by combining common stock investment and borrowing then set up a replicating portfolio

δ

The number of shares held in the replicaing portfolio corresponding to one option

No arbritage principal:

Option should cost the same as the replicating portfolio

What is risk neutral probability

Probability of the share price rise assuming no compensation for risk is required

What is the put-call parity equation

Excersise price+ value of call=value of underling asset+value of put

What is the option to wait

A real option allowing companies to postpone an investment to gather more information, reducing risk under uncertainty

What is the option to abandon

A real option that gives a company the right—but not the obligation—to terminate a project or cease operations early

What is a option to expand

A strategic real option in corporate finance that gives a company the right, but not the obligation, to increase its scale, enter new markets, or invest further