FIN 401- Ch 16 class notes

FIN 401- Ch 16 class notes - FIN 401 Principles of...

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FIN 401 – Principles of Investments and Security Markets Chapter 16: Option Valuation
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Primary Assumptions of OPMs Frictionless capital markets with no transaction costs or taxes and with information simultaneously and costlessly available to all individuals No restrictions on short sales Asset prices vary over time but have no discontinuities or jumps (continuous stochastic process) Plot asset over time, you can plot with your pen on the paper the entire time. No discrete jump in prices Constant risk-free rate No dividends
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Binomial Pricing Model What is the fair value of a call (or put) today? The Binomial Option Pricing Model (BOP) can be used to determine the fair value of an option. The assumption is that the underlying asset will attain one of two possible known prices at the end of each of a finite number of periods (given its price at the start of each period).
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Binomial Pricing Model Consider the following example: The stock of CMG today (t=0) is $100. You analyze the firm and conclude that one year from now (t=1) the stock will sell for either $125 (a rise of 25%) or $80 (a drop of 20%). The risk free rate is 8% compounded continuously.
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Binomial Pricing Model Consider a call option on CMG… Let us say that the call’s exercise price is $100 and that the expiration date is one year from now. Call value at exercise = max[0,S-X] One year from now, the call will have a value of either $25 (if CMG sells at $125) or $0 (if CMG sells at $80). X=100: if S=$125, max[0,125-100]=$25 if S=$80, max[0,80-100]=$0
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Binomial Pricing Model Share of CMG Call on CMG $100 ???? $125 $80 $25 $0 t=0 t=1 Up State Up State Down State Down State
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Three investments are of interest for us: stock option risk free bond Payoffs and Prices of Instruments: Security
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This note was uploaded on 11/15/2011 for the course FIN 401 taught by Professor Staff during the Spring '08 term at Miami University.

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FIN 401- Ch 16 class notes - FIN 401 Principles of...

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