“An option is a contract that gives one party a temporary right to buy an asset from the other at a fixed price” (Lasher, 2011, p.383). Option models were developed as a tool to evaluate stock warrants due to the complexity of the criteria. Lasher (2011) explains that the binomial model assumes the underlying security prices either increase or decrease with time until the option expires or becomes worthless. Binomial model uses a procedure which allow for points in time for the valuation date and option’s expiration date. The Black-Scholes model derived from the combined efforts of Fisher Black and Myron Scholes in which they created an option pricing model using the stock price; call premium, and underlying stock price.
The binomial model is relatively mathematically simple compared to the Black-Scholes model in which the Black-Scholes requires solutions to equations, but can be easily manipulated when utilizing a spreadsheet. Cretien (2006) defines the Black-Scholes model as a theoretical option pricing method that is based on riskless arbitrage between underlying assets such as stocks or futures contracts and options on the assets’ prices (p 38). The Black-Scholes model presumes that the options are European which can only be exercised at expiration and therefore dividends are not paid out during the life of the option. Analysts have amended the Black-Scholes model by manipulating the mathematical formulas for stock and currencies that earn interest rates on their options.
The variables for the Black-Scholes model include the underlying stock’s current price, option’s strike price, volatility of the market price of the underlying stock, time to expiration until the option’s expiration, and risk-free interest rate. T...
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...ome down to which market the investor is going to be investing and how complicated the option. The Black-Scholes model should be used for European models for faster results. The binomial model is recommended for accuracy in multiple markets and a variant of options. There are many derivatives and combinations of the Black-Scholes and binomial models to try and make the models more simplistic, faster and accurate; but as I researched and read upon each model there were advantages and disadvantages to all of the models.
Works Cited
Cretien, P. D. (2006). Comparing option pricing models. Trading Techniques, 35 (11). pp. 38- 41. Retrieved from http://go.galegroup.com/ps/i.do?id=GALE%7CA151652611&v =2.1&u=oran95108&it=r&p=ITOF&sw=w&asid=70e57b71806544033d7b73f3540affdd
Lasher, W. R. (2011). Practical financial management (6th ed.). Mason, OH: South-Western.
a high chance of loss. The Investor must control his nerves when ups or downs come, thus pricing is much more important than timing. This subject will be discussed further in the next chapter. The price is determined by the investors evaluation and not by the average price, which can result from poor competence from the Enterprise’s side (Buffett Books K, 2017).
In the following essay I will be comparing and contrasting the effectives of capital asset pricing model (CAPM), Arbitrage Pricing Theory, and the Fama-French three factor model when estimating the cost of capital and explaining performance of investment portfolios.
After evalutating both the Black-Scholes Model and the Brownian Motion, we have come to know that the Black-Scholes Model is quite predictive as it gets close to the observed price. We found that with the Brownian motion it may take on negative values which results certain modelling prices to be frowned upon , hence making Black-Scholes Model more realistic. As we ventured in this study, we found that there is still more research to be done since many of the modern option models stems from the Black-Scholes model. Thus making the modern option pricing models more
When discussing the cost of equity capital, or the rate of return required by investors for their share expenses, there are three main models widely used for analyzation. These models are the dividend growth model, which operates on the variable of growth and future trends, the capital asset pricing model (CAPM), which operates on the premise that higher returns are a result of higher risk, and the arbitrage pricing theory (APT), which has a more flexible set of criteria than CAPM and takes advantage of mispriced securities
Ross, S.A., Westerfield, R.W., Jaffe, J. and Jordan, B.D., 2008. Modern Financial Management: International Student Edition. 8th Edition. New York: McGraw-Hill Companies.
“Options give you the right (without the obligation) to transact a security at a predetermined price within a certain time period. In a call option, the buyer has the right (but is not required) to buy an agreed quantity of a commodity or financial instrument (called the underlying asset) from a seller by a certain date (the expiry) for a certain price (the strike price). A put option is the right to sell the underlying stock at a predetermined strike price by a certain date” (Call Option vs Put Option, 2014).
Roll, R. & Ross, S.A.(1980).An empirical investigation of arbitrage pricing theory. Journal of Finance, 35(5), 1073-1103.
Capital Asset Pricing Model (CAPM) is an ex ante concept, which is built on the portfolio theory established by Markowitz (Bhatnagar and Ramlogan 2012). It enhances the understanding of elements of asset prices, specifically the linear relationship between risk and expected return (Perold 2004). The direct correlation between risk and return is well defined by the security market line (SML), where market risk of an asset is associated with the return and risk of the market along with the risk free rate to estimate expected return on an asset (Watson and Head 1998 cited in Laubscher 2002).
We have devoted our study to apply statistical methods to stochastic differential equations, initially to estimate by the historical method, which uses the property of independence and normality of the outputs. The Black-Scholes model and its alternatives are largely used by the professionals. For that, the estimate of its parameters deserves that we interested in other techniques more adapted: discrete method. The discrete method makes it possible to estimate the parameters of Black-Scholes model in the case of the discrete paths. In this method, it is necessary to observe the process during a certain interval of time i.e. to use all the observations of the paths. The discrete method being based on the criterion which minimizes the variances of the estimators and the small errors with the true values of the share price of gold(Khaldi Khaled, 2010).
After the financial crisis of the late 1990s, the demands for risk management tools have increased. The investors have been effectively utilizing such products as KOSPI 200 futures and options, 3-Year KTB futures and USD futures to meet their hedging needs.
Hoadley Trading & Investment Tools (2011). Option pricing models and the greeks. Retrieved on May 24, 2011 from http://www.hoadley.net/options/bs.htm
Ravi, Sreenivasan. "Statistical And Probabilistic Methods In Actuarial Science." Journal Of The Royal Statistical Society: Series A (Statistics In Society) 172.2 (2009): 530. Business Source Premier. Web. 25 Oct. 2013.
Among all the programs available, I firmly believe that the Master in Finance program at Princeton University will be the ideal preparation for my career because of its strong emphasis on quantitative techniques with practical business problem solving. The core courses offered by the program will help me build concrete foundation in financial theories and computational methods; the elective courses, such as Forecasting and Time Series Analysis, will further enhance my modeling techniques for financial forecasting in a broader application. Besides excellent teaching fellows at Princeton University, the close personal attention from academic and career advisors will be invaluable to my professional growth. Furthermore, the small cla...
Every model has a purpose. Industrial engineers use production line models to show potential future bottlenecks in the production process based on the changes in certain variables. In finance, models are employed to show such things as the value of a company, the projected cash flow of a company, or the projected financing needs of a company. The creation of tight, solid models is what separates the good analysts from the stars.
This paper will define and discuss five financial theories and how they impact business decisions made by financial managers. The theories will be the Modern Portfolio Theory, Tobin Separation Theorem, Equilibrium Theory, Arbitrage Pricing Theory (APT), and the Efficient Markets Hypothesis.