Brailsford3eSM_Ch16

Brailsford3eSM_Ch16 - Chapter 16 Option contracts Learning...

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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 risk-free hedge and its importance to option pricing compare the characteristics of European-type options and American-type 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 Black-Scholes 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 pay-offs 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 risk-free rate of return (r) and dividends or cash flows expected during the life of the option (D). 2 Put-call 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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2 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 European-type options 1 Valued using the Binomial model, developed by Cox, Ross and Rubinstein (1976), where the principal behind the model is to create a risk-free hedge. 2 Alternatively the Black-Scholes model is used. 16.6 Valuing American-type options 1 Requires testing for exercise at all periods as well as at expiry.
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Brailsford3eSM_Ch16 - Chapter 16 Option contracts Learning...

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