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Copyright © 2006 Nelson Australia Pty Limited
Chapter 16
Option contracts
Learning objectives
After the completion of this chapter, you should be able to:
●
explain how option prices are bounded and describe the factors that affect option prices
●
understand the binomial model of option pricing
●
explain the concept of a riskfree hedge and its importance to option pricing
●
compare the characteristics of Europeantype options and Americantype options
●
apply the basic option pricing models
●
understand the use of options in solving hedging and trading problems
Key points
1
This chapter introduces the option contract. Key features of these options are limits to
prices, and how options are priced.
2
The price of options implicitly relies on the role of lognormal distribution and are often
priced under either the Binomial or BlackScholes models.
Chapter outline
16.1 Introduction
1
An option is a contract that gives one party the right but not the obligation to buy or sell a
particular asset or contract at an agreed price with delivery at an agreed time or over an
agreed period of time.
2
The key characteristic of an option is the ability of the option purchaser to choose whether
to exercise the option.
16.2 Option payoffs
1
Payoff diagrams show the payoff should the option be exercised immediately.
2
Option value is composed of the intrinsic value (valuation if the option is exercised
immediately) and time value.
16.3 The determinants of option prices
1
Option prices are affected by six factors; underlying asset price (P), exercise price (X), time
to expiry (t), the standard deviation of asset returns (
σ
), the riskfree rate of return (r) and
dividends or cash flows expected during the life of the option (D).
2
Putcall parity equates the cost of two portfolios. The first portfolio consists of a bought call
option and the second portfolio consists of a bought put option and underlying asset
combined with borrowing the present value of the exercise price of the option.
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Investments: Concepts and Applications Solutions Manual
Copyright © 2006 Nelson Australia Pty Limited
16.4 The underlying asset
1
The distribution of underlying asset prices must be modelled before an option can be valued
explicitly.
2
Generally the underlying asset price is assumed to be log normally distributed.
3
Where a lognormal process is chosen for asset prices the price change process is often
described as a Wiener process.
16.5 Valuing Europeantype options
1
Valued using the Binomial model, developed by Cox, Ross and Rubinstein (1976), where
the principal behind the model is to create a riskfree hedge.
2
Alternatively the BlackScholes model is used.
16.6 Valuing Americantype options
1
Requires testing for exercise at all periods as well as at expiry.
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