Option pricing models
The option pricing models is somewhat of a gamble to some investors and a to others a pattern-based method of investing. According to Hoadley Trading & Investment tools (2011), Black-Scholes model is used most commonly to determine the fair market value of the option in play. This model uses five key determinants of an option’s price such as price, strike price, volatility, time to expiration and short term interest rate. This model will let you calculate the option prices quickly but unfortunately it is not too accurate. This limitation is due to it inability to analyze a continuous flow of possibilities, instead the model can only calculate the option price at one point in time.
One must get familiar with the call option and put options of option pricing to see how transactions are made. The call option is a contract between the buyer and the seller. The buyer “has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller” (Call option, 2011). The buyer has to pay a small fee for this right to make the seller sell upon the buyer’s choosing. The put option is a contract between the buyer and seller “to exchange an asset, the underlying, for a specified amount of cash, the strike, by a predetermined future date, the expiry or maturity” (Put option, 2011).
Strike price is the fixed price at which the owner of the option can sell or buy. For example, if an option A Put has a strike price of $40 a share then when the option is exercised the owner can sell 50 shares of option B for $40 per share.
The intrinsic value is calculated by taking the sum of the future income generated from the option and subtracting it from the pr...
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Ehrhardt, M. C., & Brigham, E. F. (Feb 2010). Corporate Finance: A Focused Approach. Mason, OH. South-Western Cengage Learning.
Hoadley Trading & Investment Tools (2011). Option pricing models and the greeks. Retrieved on May 24, 2011 from http://www.hoadley.net/options/bs.htm
McClure, B. (2011). DCF analysis: Calculating the discount rate. Investopedia. Retrieved on May 24, 2011 from http://www.investopedia.com/university/dcf/dcf3.asp
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Troy, PhD., Leo. Almanac of Business and Industrial Financial Ratios. 31st edt. (2000) (page 159) Paramus, NJ: Prentice Hall.
Discounted cash flow is a valuation technique that discounts projected cash inflows and outflows to evaluate the potential value of an investment. There are three discounted cash flow methods: Net Present Value (NPV), Profitability Index (PI) and Internal Rate of Return (IRR). The net present value discounts all cash inflows and outflows at a minimum rate of return, which is usually the cost of capital. The profitability index refers to the ratio of the present value of cash inflow to the present value of cash outflows. The internal rate of return refers to the interest rate that discounts cash inflow projections to the present to ensure that the present value of cash inflows is equivalent to the present value of cash outflows (Brown, 1992).
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.
William Sharpe, Gordon J. Alexander, Jeffrey W Bailey. Investments. Prentice Hall; 6 edition, October 20, 1998
The economic rationality assumption has given an important connation for the market efficiency, as it has been the base to carry out the construction of the modern knowledge in standard finance. Resulting in the development of the most important insights in finance, such as arbitrage pricing theory of Miller and Modigliani, the Markowitz portfolio optimization, the capital asset pricing theory of Sharp, Lintner and Sharp and the option-pricing model of Black, Scholes and Merton (Pompian, 2006 and Lo, 2005). At this stage, these advances provide a sophisticated mathematical approach to explain what happen in real life. As a result, of these advances, individuals who trade stocks and bonds use these theories under the assumption that the assets they are investing in have similar value to the prices they are paying. This way, according to the market efficiency, current prices reflect all relevant information so trading stocks in an attempt to exceed the benchmark or to produce returns above average will not be possible without taking risk above the average since with arbitrage would make go back prices to their real or fundamental value (Malkiel, 2003).
“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).
The most common risk free interest rate is the short term US Treasury bond and is seen as a proxy. It is therefore valued as the default risk entity. They are seen as the most liquid bonds on the market (Buttonwood, 2014). It is considered easy to obtain and therefore most efforts are focused estimating the risk parameters of individual companies and risk premiums based on it (Damodaran, 2011). Risk free rate of return is critical for measuring present value. It recognizes that cash today is not the same as it is in the future. If invested we should expect that the time value of money will remain the same. These are key elements in the financial world and important indicators for investors.
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Financial Future: Where Will it be in 10 Years? Retrieved on November 20, 2013 from
The calculation of intrinsic value, though, is not so simple. As the definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, will almost inevitably come up with at least slightly different intrinsic value figures.
Block, S. B., & Hirt, G. A. (2005). Foundations of financial management. (11th ed.). New York: McGraw-Hill.
An offer is the willingness to contract with a specific set or terms made by the offeror that if accepted that person or individual is bound by a contract.
Business finance has taught me how to manage risk and return as well as making capital investment decisions throughout the semester. Professor Schott has gone through each chapter carefully well making sure that each student grasps each concept before moving on. He has used many tools such as LearnSmart, lectures and homework assignments to make sure that us students have a good idea of the concept before giving us exams.
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