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optionbasics - Option Pricing Basics Aswath Damodaran...

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Aswath Damodaran 1 Option Pricing Basics Aswath Damodaran
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Aswath Damodaran 2 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 3 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 4 Payoff Diagram on a Call Price of underlying asset Strike Price Net Payoff on Call
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Aswath Damodaran 5 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 6 Payoff Diagram on Put Option Price of underlying asset Strike Price Net Payoff On Put
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