Valuation Techniques - Option Pricing

Question 1

Briefly describe the methodology of the binomial option pricing model.

Answer 1

The binomial option-pricing model is a method that can be generalized for the valuation of options. It uses a tree or network diagram to represent points in time between the present (valuation date) and the expiration of the option and uses probabilities to work backward in assigning value to each branch in the tree to derive a value at the present (valuation date).

Question 2

What are some major limitations of the original Black-Scholes option pricing model?

Answer 2

• It is appropriate only for European call options, which permit exercise only at the expiration rate.
• It assumes options are for stocks that pay no dividends.
• It assumes options are for stocks whose price increases in small increments.
• It assumes the risk-free rate of return remains constant during life of the option.
• It assumes there are no transaction costs or taxes associated with the options.

Question 3

What are some major advantages of the original Black-Scholes option pricing model?

Answer 3

• It assigns a probability factor to the likelihood that the price of the stock will pay off within the time to expiration.
• It assigns a probability factor to the likelihood that the option will be exercised.
• It discounts the exercise price to present value.

Question 4

What is the Black-Scholes option-pricing model?

Answer 4

The Black-Scholes model is a mathematical formula for valuing stock options, which are derivative instruments (and certain other instruments). The original model was developed to value European-style options, which permit exercise only at the expiration date of the option.