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 . Since it is a right and not an obligation, the holder canchoose not to exercise the right and allow the OPTION to expire.
riskless interest rate also enters into the valuation of options when the present value of the exercise price is calculated, since the exercise price does not have to be paid (received) until expiration on calls (puts). Increases in the interest rate will increase the value of calls and reduce the value of puts.
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