Group 6 Flashcards
Common Techniques derived from Black and Scholes’ insights
Black-Scholes Option Pricing Model
Binomial Option Pricing Model
Risk-Neutral Probabilities
Risk and Return of an Option
Corporate Applications of Option Pricing
gives holder the right (but not the obligation) to purchase an asset at some future date.
Call option -
gives the holder the right to sell an asset at some future date.
Put option -
the price at which the holder agrees to buy or sell the share of stock when the option is exercised.
Strike price or exercise price -
the last date on which the holder has the right to exercise the option
Expiration date -
can be exercised on any date up to, and including the exercise date.
American option
can be exercised only on the expiration date.
European option
It can be derived from the Binomial Option Pricing Model by making the length of each period, and the movement of the stock price per period, shrink to zero and letting the number of periods grow infinitely large.
Black-Scholes Option Pricing Model
5 Input Parameters to price the call
Stock Price
Strike Price
Exercise Date
Risk-free Rate
Volatility of the Stock
An option can be valued using a portfolio that replicates the payoffs of the option in different states.
Binomial Option Pricing Model
It assumes two possible states for the next time period, given today’s state.
Binomial Option Pricing Model
a portfolio of other securities that has exactly the same value in one period as the option.
Two-State Single-Period Model
there are more than two possible outcomes for the stock price in the real world.
Multiperiod Model
also known as state-contingent prices, state prices, or martingale prices.
Risk-Neutral Probabilities
probabilities under which the expected return of all securities equals the risk-free rate. These probabilities can be used to price any other asset for which the payoffs in each state are known.
Risk-Neutral Probabilities
any security whose payoff depends solely on the prices of other marketed assets.
Derivative security:
the basis for a common technique for pricing derivative securities called Monte Carlo simulation.
Risk-neutral pricing method:
The beta of an option can also be calculated by computing the beta of its replicating portfolio.
Risk and Return of an Option
For stocks with ____ betas, calls will have larger betas than the underlying stock, while puts will have ______ betas.
positive;negative
Expected returns and beta are _____ related.
linearly
two Corporate Applications of Option Pricing:
unlevering the beta of equity and calculating the beta of risky debt and deriving the approximation formula to value debt overhang
Uses of Option Pricing Methods: (give 2)
- assess potential investment distortions that might arise due to debt overhang, or the incentive for asset substitution and risk-taking.
- evaluate state-contingent costs, such as financial distress costs.
- enhance the value of the firm.
they discovered the Black Scholes Model and won the Novel Prize Award in 1997
Robert Merton
Myron Scholes
Fischer Black
In the randomization, the ________ are used, and so the average payoff can be discounted at the risk-free rate to estimate the derivative security’s value.
risk-neutral probabilities
