Good The Valuation And Characteristics Of Bonds And Stocks Research Paper Example
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Pricing Options Using Black-Scholes Model
In financial management, this model is widely used to price the European call and put options while ignoring dividend payments. Primarily, there are six major factors that impact the options pricing while Black-Scholes Model is used . These factors are as follows:
Market Price of Underlying Asset
As the most influential factor, a rise in current market price of an underlying asset tends to increase the call price and reduces the price of a put option. Vice versa will be the effect when the market price of underlying commodity declines.
Expected Volatility in Prices
Volatility, in financial markets, represents the extent to which the current market price of an underlying asset fluctuates. As per market sentiments, higher volatility characterized by the underlying assets generally carries with it higher option premiums. Option value will be higher in case of increased expected volatility.
Intrinsic value of an option is determined by the difference between current price of the underlying commodity and an option’s strike price. As an option becomes in-the-money where the strike or exercise price is favorable against current market price, this situation increases the premium. Usually, in contrast, option premium declines as the option becomes further out-of-the-money .
Time until Maturity
The longer the maturity of an option, the more profitable (in-the-money) it will be. As the date of expiry becomes near, the time value of an option declines. If the underlying asset has higher volatility, price fluctuation before expiration will certainly be high and vice versa.
Current Interest Rate Level and Dividend Payments
Increase in interest rates tends to increase call premiums and reduce premiums of put options due to incurring of costs coupled with owning the commodity. Such a cost will either be in the form of payment of interest expense or loss of interest income. Increase in dividend payments decreases call price while increasing put prices and vice versa.
Pricing Options Using Binomial Model
An alternative option pricing method to Black-Sholes model is the Binomial model that incorporates the binomial tree concept. As similar to the Black-Scholes Model, this tree based model is also influenced heavily by the market price of any underlying commodity.
Unlike Black-Scholes Model which is affected by current interest rate level, options priced through the Binomial Model are affected by interest rate volatility and possible expectations. This is so because Binomial Model could be extended to number of periods and each change in interest rate level represents a separate random event . In contrast, interest rates in Black-Scholes Model are expressed in a compounded form.
Overall, this model is influenced in a similar way as for Black-Scholes model by six factors mentioned in this paper. Both the models attempt to properly price the value of underlying asset or commodity of the early expiration . The only factors which are different in both of these models are expressed in the following table:
Brigham, E., & Ehrhardt, M. (2013). Financial Management: Theory & Practice. Cengage Learning.
Fabozzi, F. J. (2007). Fixed Income Analysis. John Wiley & Sons.
Ianieri, R. (2009). Option Theory and Trading: A Step-by-Step Guide To Control Risk and Generate Profits. John Wiley & Sons.
Kevin, S. (2010). Commodity And Financial Derivatives. PHI Learning Private Limited.
Sheeba, K. (2011). Financial Management. Pearson Education India.
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