Chapter 9 - Option pricing

Abstract

This chapter presents a discussion on option pricing. The chapter discusses the general properties of the stock options. Furthermore, the option pricing theory is presented in the chapter using two approaches: the method of the binomial trees and the classical Black-Scholes theory. In finance, derivatives are the instruments whose price depends on the value of another asset. In particular, the stock option is a derivative whose price depends on the underlying stock price. Derivatives have also been used for many other assets—including, but not limited to, commodities (e.g., cattle, lumber, and copper), Treasury bonds, and currencies. The chapter also discusses the forward and future contracts. In contrast to the forward and future contracts, “options” give an option holder the right to trade an underlying asset rather than the obligation to do this. In particular, the call option gives its holder the right to buy the underlying asset at a specific price (so-called exercise price or strike price) by a certain date (expiration date or maturity). The “put option” gives its holder the right to sell the underlying asset at a strike price by an expiration date. The chapter concludes with a discussion on the Black–Scholes theory and binomial trees.