Page 109 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management Mahesh Kumar Sarva, Lovely Professional University

Notes Unit 8: Option Pricing

CONTENTS
Objectives
Introduction
8.1 Primary Option Pricing Factors

8.2 Put-Call Parity
8.3 Options Pricing Models
8.3.1 Binomial Options Pricing Model (BOPM)

8.3.2 The Black and Scholes Model
8.4 Summary
8.5 Keywords
8.6 Review Questions
8.7 Further Readings

Objectives

After studying this unit, you will be able to:
 Identify the primary option pricing factors
 Describe put-call parity

 Explain the option pricing model
Introduction

Modern option pricing techniques are often considered among the most mathematically complex
of all applied areas of finance. Financial analysts have reached the point where they are able to
calculate, with alarming accuracy, the value of a stock option. Most of the models and techniques
employed by today's analysts are rooted in a model developed by Fischer Black and Myron
Scholes in 1973.
The price of an option contract is that amount which is paid by the option buyer to the option
seller. This is otherwise, known as option premium. Like, other price mechanism the premium
(option price) on a particular option contract is computed by the demand and supply of the
underlying asset (option). There are two types of option price i.e., intrinsic value and time value.
The intrinsic value of a call option is that amount by which stock price exceeds the strike price,
whenever the option is in-the-money. This intrinsic value will be zero when the stock price is
less than the option strike price. On the other hand, the intrinsic value of put option is that
amount by which strike price exceeds the stock price, whenever the option is in-the-money. This
intrinsic value of put option will be zero when the strike price is less than the stock price.

Did u know? What is the time value of an option?
Time value of an option is the excess of option price over the intrinsic value.

104 LOVELY PROFESSIONAL UNIVERSITY