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 option to someone else than by exercising the options. While early exercise is not optimal generally, there are at least two exceptions to this rule. One is a case where the underlying asset pays large dividends, thus reducing the value of the asset, and any call options on that asset. In this case, call options may be
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