Options Pricing
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finance Finance refers to monetary resources and to the study and Academic discipline, discipline of money, currency, assets and Liability (financial accounting), liabilities. As a subject of study, is a field of Business administration, Business Admin ...
, a price (premium) is paid or received for purchasing or selling options. The calculation of this premium will require sophisticated mathematics.


Premium components

This price can be split into two components: intrinsic value, and time value (also called "extrinsic value").


Intrinsic value

The ''intrinsic value'' is the difference between the underlying spot price and the strike price, to the extent that this is in favor of the option holder. For a
call option In finance, a call option, often simply labeled a "call", is a contract between the buyer and the seller of the call Option (finance), option to exchange a Security (finance), security at a set price. The buyer of the call option has the righ ...
, the option is in-the-money if the underlying spot price is higher than the strike price; then the intrinsic value is the underlying price minus the strike price. For a
put option In finance, a put or put option is a derivative instrument in financial markets that gives the holder (i.e. the purchaser of the put option) the right to sell an asset (the ''underlying''), at a specified price (the ''strike''), by (or on) a ...
, the option is in-the-money if the ''strike'' price is higher than the underlying spot price; then the intrinsic value is the strike price minus the underlying spot price. Otherwise the intrinsic value is zero. For example, when a DJI call (bullish/long) option is 18,000 and the underlying DJI Index is priced at $18,050 then there is a $50 advantage even if the option were to expire today. This $50 is the intrinsic value of the option. In summary, intrinsic value: : = current stock price − strike price (call option) : = strike price − current stock price (put option)


Extrinsic (Time) value

The option premium is always greater than the intrinsic value up to the expiration event. This extra money is for the risk which the option writer/seller is undertaking. This is called the time value. Time value is the amount the option trader is paying for a contract above its intrinsic value, with the belief that prior to expiration the contract value will increase because of a favourable change in the price of the underlying asset. The longer the length of time until the expiry of the contract, the greater the time value. So, : Time value = option premium − intrinsic value


Other factors affecting premium

There are many factors which affect option premium. These factors affect the premium of the option with varying intensity. Some of these factors are listed here: * Price of the
underlying In finance, a derivative is a contract between a buyer and a seller. The derivative can take various forms, depending on the transaction, but every derivative has the following four elements: # an item (the "underlier") that can or must be bou ...
: Any fluctuation in the price of the underlying stock/index/commodity obviously has the largest effect on the premium of an option contract. An increase in the underlying price increases the premium of call options and decreases the premium of put options. The reverse is true when the underlying price decreases. *
Strike price In finance, the strike price (or exercise price) of an option is a fixed price at which the owner of the option can buy (in the case of a call), or sell (in the case of a put), the underlying security or commodity. The strike price may be set ...
: The distance of the strike price from spot also affects option premium. If NIFTY goes from 5000 to 5100, the premium of 5000 strike and of 5100 strike will change more than a contract with strike of 5500 or 4700. * Volatility of underlying: The underlying security is a constantly changing entity. The volatility is the degree of its price fluctuations. A share which fluctuates 5% on either side on daily basis has more volatility than stable blue chip shares whose fluctuation is more benign at 2–3%. Volatility affects calls and puts alike. Higher volatility increases the option premium because of the greater risk it brings to the seller. * Payment of
Dividend A dividend is a distribution of profits by a corporation to its shareholders, after which the stock exchange decreases the price of the stock by the dividend to remove volatility. The market has no control over the stock price on open on the ex ...
: Payment of Dividend does not directly impact the value of derivatives but indirectly impacts it through the stock price. Whenever a dividend is paid, the stock goes ex-dividend, therefore the price will go down which will results in an increase in put premiums and decrease in call premiums. Apart from above, other factors like bond yield (or
interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, ...
) also affect the premium. This is because the money invested by the seller can earn this risk free income in any case and hence while selling options. The seller has to earn more than this because of the higher risk it is taking.


Pricing models

Because the values of option contracts depend on a number of different variables in addition to the value of the underlying asset, they are complex to value. There are many pricing models in use, although all essentially incorporate the concepts of
rational pricing Rational pricing is the assumption in financial economics that asset prices – and hence asset pricing models – will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". This assu ...
(i.e.
risk neutral In economics and finance, risk neutral preferences are preference (economics), preferences that are neither risk aversion, risk averse nor risk seeking. A risk neutral party's decisions are not affected by the degree of uncertainty in a set of out ...
ity),
moneyness In finance, moneyness is the relative position of the current price (or future price) of an underlying asset (e.g., a stock) with respect to the strike price of a derivative, most commonly a call option or a put option. Moneyness is firstly a th ...
,
option time value In finance, the time value (TV) (''extrinsic'' or ''instrumental'' value) of an option (finance), option is the premium a rational investor would pay over its ''current'' exercise value (intrinsic value (finance), intrinsic value), based on the pro ...
and put–call parity. The valuation itself combines (1) a model of the behavior ( "process") of the underlying price with (2) a mathematical method which returns the premium as a function of the assumed behavior. The models in (1) range from the (prototypical)
Black–Scholes model The Black–Scholes or Black–Scholes–Merton model is a mathematical model for the dynamics of a financial market containing Derivative (finance), derivative investment instruments. From the parabolic partial differential equation in the model, ...
for equities, to the
Heath–Jarrow–Morton framework The Heath–Jarrow–Morton (HJM) framework is a general framework to model the evolution of interest rate curves – instantaneous forward rate curves in particular (as opposed to simple forward rates). When the volatility and drift of the ...
for interest rates, to the
Heston model In finance, the Heston model, named after Steven L. Heston, is a mathematical model that describes the evolution of the volatility of an underlying asset. It is a stochastic volatility model: such a model assumes that the volatility of the asset ...
where volatility itself is considered
stochastic Stochastic (; ) is the property of being well-described by a random probability distribution. ''Stochasticity'' and ''randomness'' are technically distinct concepts: the former refers to a modeling approach, while the latter describes phenomena; i ...
. See
Asset pricing In financial economics, asset pricing refers to a formal treatment and development of two interrelated Price, pricing principles, outlined below, together with the resultant models. There have been many models developed for different situations, ...
for a listing of the various models here. As regards (2), the implementation, the most common approaches are: * Closed form, analytic models: the most basic of these are the Black–Scholes formula and the
Black model The Black model (sometimes known as the Black-76 model) is a variant of the Black–Scholes option pricing model. Its primary applications are for pricing options on future contracts, bond options, interest rate cap and floors, and swaptions. ...
. *
Lattice models Lattice may refer to: Arts and design * Latticework, an ornamental criss-crossed framework, an arrangement of crossing laths or other thin strips of material * Lattice (music), an organized grid model of pitch ratios * Lattice (pastry), an ...
(Trees):
Binomial options pricing model In finance, the binomial options pricing model (BOPM) provides a generalizable numerical method for the valuation of options. Essentially, the model uses a "discrete-time" ( lattice based) model of the varying price over time of the underlying fin ...
;
Trinomial tree The trinomial tree is a Lattice model (finance), lattice-based computational model used in financial mathematics to price option (finance), options. It was developed by Phelim Boyle in 1986. It is an extension of the binomial options pricing model, ...
* Monte Carlo methods for option pricing *
Finite difference methods for option pricing Finite difference methods for option pricing are Numerical analysis, numerical methods used in mathematical finance for the valuation of Option (finance), options. Finite difference methods were first applied to Valuation of options, option pricing ...
* More recently, the volatility surface-aware models in the
local volatility A local volatility model, in mathematical finance and financial engineering, is an option pricing model that treats Volatility (finance), volatility as a function of both the current asset level S_t and of time t . As such, it is a generalisati ...
and
stochastic volatility In statistics, stochastic volatility models are those in which the variance of a stochastic process is itself randomly distributed. They are used in the field of mathematical finance to evaluate derivative securities, such as options. The name ...
families. The Black model extends Black-Scholes from equity to
options on futures In finance, a futures contract (sometimes called futures) is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The item tr ...
, bond options, swaptions, (i.e. options on swaps), and interest rate cap and floors (effectively options on the interest rate). The final four are
numerical method In numerical analysis, a numerical method is a mathematical tool designed to solve numerical problems. The implementation of a numerical method with an appropriate convergence check in a programming language is called a numerical algorithm. Mathem ...
s, usually requiring sophisticated derivatives-software, or a numeric package such as
MATLAB MATLAB (an abbreviation of "MATrix LABoratory") is a proprietary multi-paradigm programming language and numeric computing environment developed by MathWorks. MATLAB allows matrix manipulations, plotting of functions and data, implementat ...
. For these, the result is calculated as follows, even if the numerics differ: (i) a risk-neutral distribution is built for the underlying price over time (for non-European options, at least at each exercise date) via the selected model, as calibrated to the market; (ii) the option's payoff-value is determined at each of these times, for each of these prices; (iii) the payoffs are discounted at the
risk-free rate The risk-free rate of return, usually shortened to the risk-free rate, is the rate of return of a hypothetical investment with scheduled payments over a fixed period of time that is assumed to meet all payment obligations. Since the risk-free r ...
, and then averaged. For the analytic methods, these same are subsumed into a single probabilistic result; see .


Post crisis

After the
2008 financial crisis The 2008 financial crisis, also known as the global financial crisis (GFC), was a major worldwide financial crisis centered in the United States. The causes of the 2008 crisis included excessive speculation on housing values by both homeowners ...
,
counterparty credit risk Credit risk is the chance that a borrower does not repay a loan or fulfill a loan obligation. For lenders the risk includes late or lost interest and principal payment, leading to disrupted cash flows and increased collection costs. The loss ...
considerations were brought into the valuation, previously using the risk-free rate to discount the payoff. There are three major developments here regarding option pricing: Derivatives Pricing after the 2007-2008 Crisis: How the Crisis Changed the Pricing Approach
Didier Kouokap Youmbi,
Bank of England The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694 to act as the Kingdom of England, English Government's banker and debt manager, and still one ...
Prudential Regulation Authority
#For discounting, the overnight indexed swap (OIS) curve is typically used for the "risk free rate", as opposed to
LIBOR The London Inter-Bank Offered Rate (Libor ) was an interest rate average calculated from estimates submitted by the leading Bank, banks in London. Each bank estimated what it would be charged were it to borrow from other banks. It was the prim ...
as previously; see . Relatedly, the "
Multi-curve framework In finance, an interest rate swap (finance), swap (IRS) is an interest rate derivative, interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a Interest rate derivative#Linear and non-linear ...
" is now standard in the valuation of interest rate derivatives and for
fixed income analysis Fixed income analysis is the process of determining the value of a debt security based on an assessment of its risk profile, which can include interest rate risk, risk of the issuer failing to repay the debt, market supply and demand for the secu ...
more generally. #To ensure that option prices are consistent with the volatility surface, the numerics will incorporate a zeroth calibration step, such that observed prices are returned before new prices and / or "greeks" can be calculated. To do so, banks will apply
local Local may refer to: Geography and transportation * Local (train), a train serving local traffic demand * Local, Missouri, a community in the United States Arts, entertainment, and media * ''Local'' (comics), a limited series comic book by Bria ...
or
stochastic volatility In statistics, stochastic volatility models are those in which the variance of a stochastic process is itself randomly distributed. They are used in the field of mathematical finance to evaluate derivative securities, such as options. The name ...
models, such as the Heston model mentioned above (or less common, implied trees). #The risk neutral value, no matter how determined, is adjusted for the impact of
counterparty credit risk Credit risk is the chance that a borrower does not repay a loan or fulfill a loan obligation. For lenders the risk includes late or lost interest and principal payment, leading to disrupted cash flows and increased collection costs. The loss ...
via a
credit valuation adjustment A Credit valuation adjustment (CVA), in financial mathematics, is an "adjustment" to a derivative's price, as charged by a bank to a counterparty to compensate it for taking on the credit risk of that counterparty during the life of the tran ...
, or CVA, as well as various of the other
XVA X-Value Adjustment (XVA, xVA) is an hyponymy and hypernymy, umbrella term referring to a number of different "valuation adjustments" that banks must make when assessing the value of derivative (finance), derivative contracts that they have entered ...
which may also be appended.


See also

* *
Financial engineering Financial engineering is a multidisciplinary field involving financial theory, methods of engineering, tools of mathematics and the practice of programming. It has also been defined as the application of technical methods, especially from mathe ...
* *


References

{{Authority control Options (finance) Mathematical finance