Transcription of CHAPTER 5 OPTION PRICING THEORY AND MODELS
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CHAPTER 5 OPTION PRICING THEORY AND MODELS
1 CHAPTER 5 OPTION PRICING THEORY AND MODELSIn general, the value of any asset is the present value of the expected cash flows onthat asset. In this section, we will consider an exception to that rule when we will look atassets with two specific characteristics: They derive their value from the values of other assets. The cash flows on the assets are contingent on the occurrence of specific assets are called options and the present value of the expected cash flows on theseassets will understate their true value. In this section, we will describe the cash flowcharacteristics of options , consider the factors that determine their value and examine howbest to value of OPTION PricingAn OPTION provides the holder with the right to buy or sell a specified quantity ofan underlying asset at a fixed price (called a strike price or an exercise price) at or beforethe expiration date of the OPTION .
the strike price, the gross payoff is the difference between the value of the underlying asset and the strike price and the net payoff is the difference between the gross payoff and the price of the call. This is illustrated in figure 5.1 below: A put option gives the buyer of the option the right to sell the underlying asset at a
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