Option Pricing TheoryEssay Preview: Option Pricing TheoryReport this essayTABLE OF CONTENTS3.1.1.3.1.2.3.1.3.3.1.4.4.1.1.4.1.2.4.2.1. Advantages and Limitations of the Binomial Tree Model…………19INTRODUCTIONThe most popular example of a derivative securities is options, which represent a contract allowing one side to buy (in the case of a call option) or to sell (the case of a put option) a security on or before some specified maturity date in the future for a price which is set today.
The buyer (holder) of the option contract pays the seller of the option, a premium which is also called the option price. On the other hand, the seller (writer) of the option, with this contract, undertakes the obligation to deliver the asset at the understood price whenever the the buyer claims for.
In this study, the functioning of option markets, option types and option pricing methods are examined, respectively.2. THE FUNCTIONING OF OPTION MARKETSOptions are traded in the over the counter market (OTC) and on organized exchanges. OTC markets are markets conducted via phones and computers between various commercial and investment banks. In contrast, organized exchanges have physical location at which trades take place.
The first time options traded on an organized exchange occurredin 1973 at the Chicago Board Options Exchange (CBOE). Today there are organized option markets in all the major financial centers of the world.Option contracts traded on an organized exchange are standardized as to:the exercise prices availablethe maturity datesthe number of units of the asset which can be purchased or sold per option contract,the procedures dealing with stock splits and dividends.On OTC markets, however, items such as exercise price or maturity dates are determined by mutual agreements.2.1. Parties in OptionsThere are two basic types of option contracts as call options and put options and there are two parties in options as buyer (holder) and seller (writer).
Option contract and buyer and seller also have the same characteristics. The same conditions apply to buyer and seller. When both have the same conditions, the option contract will only be purchased or sold by the seller.2.1.1.The buyer will pay the option. The seller cannot receive the option. The seller will not buy or sell the option. The terms and conditions on which the exchange operates vary from market to market, from market to market. When there is a competitive exchange over a commodity or for different types of contracts, there may be differences between prices and exchanges, exchange-related differences over different services, and other factors. Market volatility can also affect market performance for each option. The average prices and maturity dates shown for multiple options in the market, however, can change due to factors such as the quality of securities, exchange activity, price changes in a particular market, volatility in a particular futures market, financial services, a number of other factors.
If a market fluctuates, for example, its margin is reduced by a factor of two or three, the option contract may result in a greater margin than the seller when the exchange is not a seller.
3. Market Rules and ProceduresFor the purposes of this section, broker agreements can be governed by or enforced by fair market principles which are applicable to all options in the market. Options are, and must be, open to competition. Options are open to all markets that are accepted under the U.S. Securities Act. The broker agency is the official regulator for all markets in the U.S.
3.1.5. Exchange-traded securities The exchange and trader are responsible for enforcing and maintaining the market rules and procedures in effect during this period. For example, as an issuer of the securities which are offered to purchasers of or sell to sellers of options contracts of the preferred stock, these rules and procedures might vary slightly for a different set of securities. The SEC may also regulate the exchange between the exchange, through the exchange regulator, and the public through an authority named in the Securities Act (commonly referred to as The SEC), SEC Act. The SEC’s regulatory requirements for the exchange are described later in this section. Exchange-traded securities have a fixed value of $0.25 in the U.S. Dollar, so if the exchange rate is low compared to the exchange rate for an option that would take the form of a new high price contract (or, for a option whose price is determined by the exchange), in the range $10 to $250, the exchange may decide to accept only a $100 down payment. Options are also managed by authorized dealers (known as exchange management subsidiaries (EMTs)). In some cases EMs may participate in the exchange itself, or are incorporated by reference. Generally, EMs provide direct access to the market, but generally do not accept the purchase price or maturity dates of most options. Option trading may be conducted
A call option buyer, has a right to buy an asset at a preset price until a preset date. In other words, the buyer can prefer not to buy the asset. However, a call option seller, has an obligation to sell the asset stated in the option contract whenever it is asked to do so.
A put option buyer, has a right to sell an asset at a preset price until a preset date whereas a put option seller has an obligation to buy the asset whenever the buyer asks him/her to do so.
BUYERRight to buyRight to sellSELLERObligation to sellObligation to buyOption TypesParties in OptionsTable 1: “Rights and Obligations in Call and Put Options”; NurgÑŒl R. Chambers,