option - Option Pricing Theory and Applications Aswath...

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Aswath Damodaran 184 Option Pricing Theory and Applications Aswath Damodaran
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Aswath Damodaran 185 What is an option? n An option provides the holder with the right to buy or sell a specified quantity of an underlying asset at a fixed price (called a strike price or an exercise price) at or before the expiration date of the option. n Since it is a right and not an obligation , the holder can choose not to exercise the right and allow the option to expire. n There are two types of options - call options (right to buy) and put options (right to sell).
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Aswath Damodaran 186 Call Options n A call option gives the buyer of the option the right to buy the underlying asset at a fixed price (strike price or K) at any time prior to the expiration date of the option. The buyer pays a price for this right. n At expiration, If the value of the underlying asset (S) > Strike Price(K) – Buyer makes the difference: S - K If the value of the underlying asset (S) < Strike Price (K) – Buyer does not exercise n More generally, the value of a call increases as the value of the underlying asset increases the value of a call decreases as the value of the underlying asset decreases
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Aswath Damodaran 187 Payoff Diagram on a Call Price of underlying asset Strike Price Net Payoff on Call
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Aswath Damodaran 188 Put Options n A put option gives the buyer of the option the right to sell the underlying asset at a fixed price at any time prior to the expiration date of the option. The buyer pays a price for this right. n At expiration, If the value of the underlying asset (S) < Strike Price(K) – Buyer makes the difference: K-S If the value of the underlying asset (S) > Strike Price (K) – Buyer does not exercise n More generally, the value of a put decreases as the value of the underlying asset increases the value of a put increases as the value of the underlying asset decreases
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Aswath Damodaran 189 Payoff Diagram on Put Option Price of underlying asset Strike Price Net Payoff On Put
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Aswath Damodaran 190 Determinants of option value n Variables Relating to Underlying Asset Value of Underlying Asset ; as this value increases, the right to buy at a fixed price (calls) will become more valuable and the right to sell at a fixed price (puts) will become less valuable. Variance in that value ; as the variance increases, both calls and puts will become more valuable because all options have limited downside and depend upon price volatility for upside. Expected dividends on the asset , which are likely to reduce the price appreciation component of the asset, reducing the value of calls and increasing the value of puts. n Variables Relating to Option Strike Price of Options ; the right to buy (sell) at a fixed price becomes more (less) valuable at a lower price. Life of the Option
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This note was uploaded on 12/01/2011 for the course FINANCE 350 taught by Professor Aswath during the Summer '10 term at NYU.

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option - Option Pricing Theory and Applications Aswath...

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