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Options Pricing and Valuation Guide

The document discusses the pricing and valuation of options, focusing on intrinsic value, moneyness, and the differences between forwards and contingent claims. It outlines factors affecting option values, such as asset price, exercise price, volatility, time to expiration, and risk-free rate. The document emphasizes how these factors influence call and put values, including the effects of holding costs and benefits.

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3 views5 pages

Options Pricing and Valuation Guide

The document discusses the pricing and valuation of options, focusing on intrinsic value, moneyness, and the differences between forwards and contingent claims. It outlines factors affecting option values, such as asset price, exercise price, volatility, time to expiration, and risk-free rate. The document emphasizes how these factors influence call and put values, including the effects of holding costs and benefits.

Uploaded by

harsoftware3
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Derivatives

Derivatives

Pricing and Valuation


of Options

LOS a Explain Pricing and Valuation of Options

Intrinsic Value and Exercise Value


Intrinsic value of European call = Max{0, (ST – X)}
Call is in the money if ST > X
Call is out of the money if ST < X
Intrinsic value of European put = Max{0, (X – ST)}
Put is in the money if ST < X
Put is out of the money if ST > X
Intrinsic or exercise value is amount in the money

© Kaplan, Inc. 2

1
LOS a Explain Pricing and Valuation of Options

Moneyness
A call and a put each have an exercise price of $40.
The underlying stock is trading at $37 per share.

Call is out of the money: $37 – $40 < 0 Intrinsic = 0

Put is in the money: $40 – $37 = $3 Intrinsic = 3

Option premium = intrinsic value + time value

Time value > 0 and decays (declines) over time to 0

© Kaplan, Inc. 3

LOS b Contrast Pricing and Valuation of Options

Forwards vs. Contingent Claims


Forward commitments have:
 zero value at initiation
 symmetric payoffs
 unlimited gains/losses (except by zero asset price)

Contingent claims have:


 positive value at issuance
 asymmetric payoffs
 max loss = option price for long puts and calls
 max gain = option price for short puts and calls

© Kaplan, Inc. 4

2
LOS b Contrast Pricing and Valuation of Options

Values of Contingent Claims


Arbitrage puts limits on the minimum and maximum values of options

© Kaplan, Inc. 5

LOS c Identify/Describe Pricing and Valuation of Options

Factors That Affect Option Values


European options
 Asset price
 Exercise price
 Volatility of asset price
 Time to expiration
 Risk-free rate
 Benefits and costs of holding assets

© Kaplan, Inc. 6

3
LOS c Identify/Describe Pricing and Valuation of Options

Factors That Affect Option Values


Higher asset price: increases call values
decreases put values

Higher exercise price: decreases call values


increases put values

Higher volatility: increases both call values and put values

© Kaplan, Inc. 7

LOS c Identify/Describe Pricing and Valuation of Options

Factors That Affect Option Values


Longer time to expiration: increases both call and put values

Except for European style puts under some conditions (long time
to expiration, high Rf, deep in-the-money)

Higher Rf: increases call values


decreases put values

© Kaplan, Inc. 8

4
LOS c Identify/Describe Pricing and Valuation of Options

Factors That Affect Option Values

Benefits of holding: decrease call values


increase put values

Carrying costs: increase call values


decrease put values

© Kaplan, Inc. 9

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