Valuation Techniques- Option Pricing

Question 1

What is an option?

Answer 1

Contract that entitles owner to buy or sell an asset at a stated price within a specified period.

Question 2

What are the two styles of options?

Answer 2

American style- Option permits exercise any time before expiration

European style- Option permits only at maturity date

Question 3

How is option value determined?

Answer 3

1) Current stock price relative to the option stated price

2) Time to expiration of option
- Longer time- more time to acquire value

3) Risk free rate of return
- Higher risk-free rate, higher the value

4) Measure of risk of option asset
- Standard deviation
- Larger the standard deviation= greater the value of option

5) Exercise price of the option

6) Dividend payment on optioned security
- Small the dividends= greater the valuation of option

Question 4

What is the black Scholes model?

Answer 4

Developed to value options under specific circumstances

Developed for European call options only

• Stock pays not dividends
• Stock prices increase in small increments
• Risk free rate is assumed constant

MODIFIED BLACK SCHOLES ALSO USES:

• Probabilities
• Probability that the option will be exercised
• Discounting of the exercise price

Question 5

What is Binomial Option Pricing Model?

Answer 5

uses Tree diagram to estimate values at a number of point in times between the valuation date and the expiration date (moving back from expiration to the measurement date)

STEPS:

1) Generate a price tree diagram- Each branch for each time period until expiration
2) Calculate the option value at each tree end node as of the expiration date
3) Calculate option at each preceding node back to present valuation date