Assignment

Of
Stock market operation

Submitted to :-
Prof.amandeep Kaur
Submitted by:-
Samandeep Kaur
m.com (finance) 2nd year
20051052

Option Pricing Models

Meaning-
Option Pricing Models are mathematical models that use certain variables
to calculate the theoretical value of an option. The theoretical value of an
option is an estimate of what an option should be worth using all known
inputs. In other words, option pricing models provide us a fair value of an
option. Knowing the estimate of the fair value of an option, finance
professionals could adjust their trading strategies and portfolios. Therefore,
option pricing models are powerful tools for finance professionals involved
in options trading.

TYPES: -
1.Binomial option pricing model: -
It is given or developed by cox in 1979. Binomial option pricing
model is very simple model that is used to price options. When to
compared to black Schule’s model and other complex models,
binomial option pricing model in mathematically simple and easy to
use.
This model is based on the concept of no arbitrage.
The assumption of no arbitrage implies that all risk-free investment
earns the free rate of return.
Assumptions- this model is based on various assumptions which
are discussed as follow: -
1. There are only two possible prices for the underlying asset
on the next day from this assumption, this model has got its
name as binomial option pricing model (Bi means two).
2. The two prices possible are the up price and down price.
3. The underlying asset does not pay any dividend.
4. The rate of interest (r) is constant throughout the life of the
option.
5. Markets are frictionless i.e. there are no taxes and no
transaction cost.
6. Investors are risk neutral i.e. investors are indifferent
towards risk
7. The model is based on the concept of arbitrage.

Binomial option model - building process

Let us consider that we have a share of a company whose
current value is so. Now in the next month, the price of this
share is going to increase by 4% (up states) or it is going to
go down by 2% (down state). No other outcome of price is
possible for this stock in next months. Lets p be the
probability of up state. therefore, the probability od down
state is 1-p:

Now let us assume that call option exists for this stock which
Mathers at the end of the month. Let the strike price of the
call option be x. now in case, the option holders decide to
excersie the call option at the end of month, what will be the
end of month, what will be pay offer?

The payoffs are given below diagram

Now, the expected payoff wing the probabilities of up state

and down state. From the above, the expected value of
payoff is,
Once the expected value of the payoff is calculated, this
expected value of payoff has to be discounted by risk free
rate to get the arbitrage free price of call option. Use
continuous discounting for discounting the expected value of
the payoff.

In some questions, the probability of up state is not given. In

such case, probability of up state can be calculated with the
formula: -

Where,
P= up state probability
R= risk free rate
D= down state factor
U= up state factor
Using the above model building process similar model can
be build for multiperiod options and also for put options.

Advantages of binomial model

1. Binomial option pricing models are mathematically simple to

use.
2. Binomial option pricing model is useful for valuing American
options which allow the owner to exercise the option at any
point in time until expiration.
3. In this model it is possible to check at every point in an
option’s life for the possibility of early exercise.
4. This binomial model approach is widely used as it is able to
handle a variety of conditions for which other models cannot
be easily applied.
5. This model is also used to value Bermudan options which can
be exercised at various points.
6. This model is considered to be more accurate, particularly for
longer dated options and options on securities with dividend
payments.

Disadvantages of binomial model

The main limitation of the binomial model is its relatively slow
speed. Even with the power of computers available today this is
not a practical solution for calculation of thousands of prices in
a short span of time.

B) BLACK SCHDLES MODEL:-

BSM is another commonly used option pricing model. This was
discovered in 1973 by the economists Fischer black and Myron
scholes. Both received Nobel memorial prize in the economics
for their discovery.
The BSM was developed for the pricing of European call
options (i.e. settled at the time of expirations). This method
requires 5 input variables: -
1. Strike price of option – example price at which can option
can be exercised.
2. The current stock price – price of underlying asset.
3. Time to expiration- time between calculations and options
exercise date.
4. Risk free rate – risk free interest rate.
5. Volatility – (standard deviation) example a measure of how
much the security prices will move in the subsequent periods.
This is the trickiest input in the option pricing model as the
historical volatility is not the most reliable input.
6. Dividend yield – was not originally the main input as this
model was developed for pricing options on non- paying
dividends stocks.

ASSUMPTIONS FOR BSM: -

1. Options is European and can only be exercised on expiration.
2. No dividends are paid out the life of option. (but frequently
adapted to account of dividends by determining the ex-
dividend rate value of underlying stock).
3. Markets are efficient i.e. movements cannot be predicted.
4. No transaction cost in buying the options compounded on
taxes.
5. Compounded returns on assets are normally distributed.
6. Risk free rate is known and constant

FORMULA: -
The formula to calculated the fair value of European calls are
ignoring dividend paid during option lifetime.

Where
C = call premium (theoretical call prices)
 S = current stock price
T = time until option exercise
K = option striking price
R = risk free interest rate
N = cumulative standard normal distribution
E = exponential term (2.7183)
S = St. deviation of stock return
n= natural log

similarly, we can calculate options price for European

put options.

Advantages :-
Speed – calculate very large number of option prices in very
short time.

Disadvantages: -
1. Only for European options.
2. Assumes dividends and risk-free notes are constant, i.e not
time is reality.
3. Assumes volatility remains constant, which is not case
because volatility fluctuates with level of supply and
demand.
4. Trading is reality generally comes with exchange fees, the
cost to buy or sell stocks and options.

CONCLUSION
Thus, we conclude that these two models are very much
beneficial for estimating the value price of the options the
two ways by which options can be valued are :-
1. Binomial option valuation model
2. Black scholes model
Option pricing models are powerful tools for finance
professionals involved in options trading.