Option Pricing Essay Example | Topics and Well Written Essays - 3250 words

alternative Pricing - Essay ExampleOptions are used by holders for leverage or for protection. The leverage purpose helps the holder to control the shares bought for a portion what they would have cost. On the other hand, protection measures are select when the holder wants to guard against expense fluctuations. He enters into a contract with the rights to acquire the stock for a resolute period and specific price. The contracts, in either case, should be highly observed and monitored for efficient outcomes. The methods used in pricing creams have been applied for courses and can only be effective if the worth of the pickaxe is achieved. This is determined by the probability that on the expiration, the option price will be on a substantial amount of money. Any holder of an option expects a gain on his underlying addition to attain the worth of holding for the time given. The Black Scholes and the Binomial method are the elaborated on below in determining the true worth of an option. The Black Scholes Model This model dates back in the twentieth century in its application. It was developed by Fisher Black and Myles Scholes in 1973 hence the design Black Scholes (Marion, 2003, 16). It is still in use today. This model uses the theoretical call price whereby the dividends amounting during the life of the option is non included in the computation. Theoretically, the price of an option (OP) has been determined by the formulae given below In this case (Simon & Benjamin, 2000, 255 Brajendra, 2011, 372) The variables in the above formulae are expressed as shown below S is the stock price X is the strike price t is the time remaining until the expiration, de noned as percent of a year r is the compounded risk-free interest rate predominant in the current market v is the annual volatility of stock price. ln is the natural logarithm N(x) is the standard normal cumulative distribution carry e is the exponential function Below are the necessary requirements for validating this model Dividends are not paid during the stock period. Variance and interest rate does not change in the course of the option contract. There is no discontinuity in the stock price i.e. a shift from one price to some other like the case of tenders. This model applies volatility and normal distribution to determine the movement of options. The Excel add-in coif can be used to calculate the normal distribution. Volatility, on the other hand, can be implied or historical. The implied volatility of an option allows market traders to observe the current prices of options to determine how volatile they are. This is done by calculate the standard deviation i.e. v2, and in this case, all other variables have to be known. Nevertheless, historical analysis is not left out. The traders have to observe the performance of the option over past years to assess volatility.