Abstract
The objective of this teaching note is to present the basic principles of discrete option pricing in simple language, with detailed jargon-free explanation and rudimentary algebra. Simple numerical examples are used to illustrate the main ideas. The basic ideas for call and put options are explained in the familiar context of dealings between a coffee shop owner, a coffee dealer and a coffee farmer. At the beginning, the reader is informed that the actual probabilities of the future states of nature are irrelevant for calculating the values of the options. First, the valuation formulas are derived by replicating the payoff structure for the options with bags of coffee and cash. Second, the valuation formulas are derived with the construction of the risk-free hedge portfolio with bags of coffee and number of options. It is hoped that this introductory exposition of discrete option pricing will facilitate the reader's engagement with other materials in option pricing, both discrete and continuous.
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