app4 - 1 2 APPENDIX 4 OPTION PRICING In general, the value...

Info iconThis preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
A4-1 1 APPENDIX 4 OPTION PRICING In general, the value of any asset is the present value of the expected cash flows on that asset. In this appendix, we will consider an exception to that rule when we will look at assets with two specific characteristics: They derive their value from the values of other assets. The cash flows on the assets are contingent on the occurrence of specific events. These assets are called options, and the present value of the expected cash flows on them will understate their true value. We will describe the cash flow characteristics of options, consider the factors that determine their value, and examine how best to value them. Cash Flows on Options There are two types of options. A call option gives the buyer of the option the right to buy the underlying asset at a fixed price, whereas a put option gives the buyer the right to sell the underlying asset at a fixed price. In both cases, the fixed price at which the underlying asset can be bought or sold is called the strike or exercise price . To look at the payoffs on an option, consider first the case of a call option. When you acquire the right to buy an asset at a fixed price, you want the price of the asset to increase above that fixed price. If it does, you make a profit, because you can buy at the fixed price and then sell at the much higher price; this profit has to be netted against the cost initially paid for the option. However, if the price of the asset decreases below the strike price, it does not make sense to exercise your right to buy it at a higher price. In this scenario, you lose what you originally paid for the option. Figure A4.1 summarizes the cash payoff at expiration to the buyer of a call option. A4-2 2 With a put option, you get the right to sell at a fixed price, and you want the price of the asset to decrease below the exercise price. If it does, you buy the asset at the current price and then sell it back at the exercise price, claiming the difference as a gross profit. When the initial cost of buying the option is netted against the gross profit, you arrive at an estimate of the net profit. If the value of the asset rises above the exercise price, you will not exercise the right to sell at a lower price. Instead, the option will be allowed to expire without being exercised, resulting in a net loss of the original price paid for the put option. Figure A4.2 summarizes the net payoff on buying a put option. With both call and put options, the potential for profit to the buyer is significant, but the potential for loss is limited to the price paid for the option.
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
A4-3 3 Determinants of Option Value What is it that determines the value of an option? At one level, options have expected cash flows just like all other assets, and that may seem like good candidates for discounted cash flow valuation. The two key characteristics of options—that they derive their value from some other traded asset, and the fact that their cash flows are contingent on the occurrence of a specific event—does suggest an easier alternative. We can create a
Background image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 10/06/2011 for the course FIN 413 taught by Professor Irfansafdar during the Summer '11 term at Rochester.

Page1 / 7

app4 - 1 2 APPENDIX 4 OPTION PRICING In general, the value...

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online