Czech University of Life Sciences

Institute of Tropics and Subtropics

Banking and Finance

Option – in financial market

By Dumitru Trifan

Prague 2012
 Option – in financial market

Content:

1.Introduction.....................................................................................................................................................3
2.Definition and origins.......................................................................................................................................3
3.Characteristics..................................................................................................................................................3
4.Valuation models.............................................................................................................................................4
4.1 Classic valuation. Black–Scholes Model...................................................................................................4

4.2 Stochastic volatility models.......................................................................................................................6

5.Implementation Models..................................................................................................................................6
5.1 Analytic techniques...................................................................................................................................6

5.2 Binomial tree pricing model......................................................................................................................6

5.3 Monte Carlo models..................................................................................................................................6

5.4 Finite difference models............................................................................................................................6

5.5 Other models.............................................................................................................................................7

6.Classifications of Options.................................................................................................................................7
7.Risks.................................................................................................................................................................7
8.Options Trade..................................................................................................................................................8
8.1 Important issues........................................................................................................................................8

9.Practice............................................................................................................................................................8
10.Importance of Options and Further Research................................................................................................8
11. Critical Reflections.........................................................................................................................................9
Conclusions.........................................................................................................................................................9
Summary.............................................................................................................................................................9
References........................................................................................................................................................10

Option – in financial market

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1.Introduction

Financial markets imply trading of different instruments with different characteristics. The world
is developing, together with financial markets so that more and more sophisticated instruments are
discovered and implemented in practice. This paper presents an important and complicated
instrument used in derivatives markets, called option. Today’s importance of options is very
accentuated within the context financial markets crisis and development, that’s way this paper will
try to emphasize the main issues linked to them and different methods for valuation, trading, hedging,
designing, market quoting and will conclude, by summarizing their practical use and importance.

2.Definition and origins

First of all, the term option, is too ambiguous and is necessary to clarify it in financial matters by a
proper definition. One of this is: “In finance, an option is a derivative financial instrument that
specifies a contract between two parties for a future transaction on an asset at a reference price (the
strike)”1 . So basically, the option represents a transactional right for the buyer, which on other side,
for the seller represents an obligation, to engage in the respective transaction, respecting the
parameters written in the contract. Options can, in principle be created for any type of underlying
asset (can be a bond, a stock, a futures contract and so on). It is obvious that the option price depends
on the value of underlying asset, more concretely, it derives from the difference between the
reference price and the value of the respective underlying asset, also a premium is added based on the
time remaining until the expiration, i.e. for options without a precise expiration date. By assuming the
obligation, the counterparty write the option, and in the case that option is sold, he collects a
payment, the premium, from the buyer. The option writer must make sure the settlement of the
underlying asset or its cash equivalent, if the case of exercise of the option.

The origins, the base of options as financial, derivative instruments was derived from famous
Black–Scholes-Merton mathematical model, articulated by Fischer Black and Myron Scholes2 in
1973 paper, “The Pricing of Options and Corporate Liabilities.”3 In essence, they derived a partial
differential equation, now called the Black–Scholes equation, which represents the price of the option
over time. Analyzing the model, it is easy to see that the Black–Scholes formula, gives the price of
European-style options. The formula led to options trading and the creation of the Chicago Board
Options Exchange. The empirical tests have emphasized that the price given by the Black–Scholes
price is very close to real, fair prices 4. The main idea behind of the derivation was to hedge perfectly
the option by buying and selling the underlying asset to eliminate risk5.

3.Characteristics

The features of options can be easy derived from the parameters of valuation models. So that
generally, these models imply the spot price of the underlying asset, risk free rate (annual rate,
assumed to be continuous compounding), volatility of returns of the underlying asset, all other
parameters being precise in the contract. All defined parameters are written in every option contract,
in a term sheet, which implies that the two counterparties will respect them. The respective contracts
can be very complicated; however, they usually contain the following specifications, which is
minimum required:

1. The right of the option holder: to buy (a call option) or the right to sell (a put option).
1
Pascucci, Andrea. PDE and Martingale Methods in Option Pricing. Berlin: Springer, 2011.
2
Nobel Price winners in Economics in 1997.
3
The interested reader can consult references to find out the histon of options as non-official financial instruments
4
Although there can be well-known discrepancies such as the “option smile”
5
Delta Hedging.
3
2. Quantity and type of the underlying asset(s).

3. Strike price (exercise price)6.

4. Expiration date, or expiry, (the last date at which the option can be exercised).

5. Settlement terms.

6. Market quotation7 .

Even that the contract is already made, the option holder has the right to sell it further to another
party. In essence, the options are not flexible in the terms of contracts, because the contracts cannot
be changed, however, in the design of the option contract can be stipulated, some parameters that
leave some flexibility to parties, for example about the settlement / delivery /expiration date.

4.Valuation models

In order to estimate the correct value of a particular option there are different quantitative
techniques8. Of course, the original, basic model is the one elaborated by Fischer Black and Myron
Scholes , however exist more sophisticated ones that model the so called volatility smile. Advanced
models require additional factors9. In general, we can define the two main valuation categories:

4.1 Classic valuation. Black–Scholes Model

The authors made a derivation of a differential equation that must be satisfied by the price of any
derivative instrument10. The use of the technique of constructing a risk-neutral portfolio which
replicates the returns of holding an option, the authors produced a closed-form solution for a
European11 option's theoretical price. The model generates parameters for hedging and risk
management of option holdings. Of course the assumptions behind the original Black–Scholes model
are not realistic, The application of the model in modern options trading is clumsy. However, even
with the “wrong” assumption base the Black–Scholes model is still one of the most important and
used methods for foundations of the options.

Assumptions:

- No arbitrage opportunity.
- Constant risk-free interest rate.
- It is possible to buy and sell any amount, even fractional, of stock.
- No transaction costs
- The stock price follows a geometric Brownian motion with constant drift and volatility.
- The underlying security does not pay a dividend.

The Black–Scholes formula calculates the price of European put and call options. The value of a
call option for a non-dividend paying underlying stock in terms of the Black–Scholes parameters is:

6
The price at which the underlying transaction will occur in the case of option execution.
7
Terms by which the option is quoted in the market to convert the quoted price into the premium, in other words, the
total amount paid by the holder to the writer.
8
These techniques are based on stochastic calculus of risk neutral pricing.
9
For example: the dependency of volatility over time, or the dynamics interest rates.
10
It have to be a non-dividend-paying stock.
11
The classification of the options will be clarified in the part 6 of this paper.
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The price of a corresponding put option based on put-call parity is:

For both, as above:

 is the cumulative distribution function of the standard normal distribution

 is the time to maturity
 is the spot price of the underlying asset
 is the strike price
 is the risk free rate (annual rate, expressed in terms of continuous compounding)
 is the volatility of returns of the underlying asset

Also from the model was derived a list of parameters that show the sensitivity of the option to
different factors, so called Greeks, the most important are:

Table 1. Main types of Greeks12.

12
Source: Option Trading – pedia.com (March 2012).
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From the formulas it is easy to see for each greek, which is the respective factor for sensitivity
analysis13. It have to be mentioned that exist more 14 greeks that measures also sensitivity of
different parameters, and some special designed greeks for different type of options14.

4.2 Stochastic volatility models

The year 1987 demonstrated some defects in used methods for valuation of the options, more
concretely, since the market crash of that year, it has been observed that option market implied
volatility of lower strike prices are typically higher than for higher strike prices, implying that
volatility is stochastic, varying for time and for the price level of the underlying security. So that,
stochastic volatility models have been made including one developed by S.L. Heston. The principal
advantage of the his model is that it can be solved in closed-form, while other stochastic volatility
models require complex numerical methods which are not practical, even with good software. Later,
from latest financial crisis also were developed new models, more complicated and advanced for
option pricing, but investors prefer more to use models with known defects like the Balck-Scholes.

5.Implementation Models

After the valuation, there are different techniques used to implement the respective models. There
are 5 major classes15.

5.1 Analytic techniques

A usual way for implementation, is to take the mathematical model and using analytical methods
find closed form solutions such as Black–Scholes and the Black model. The resulting solutions are
readily computable, and their sensitivity parameters also.

5.2 Binomial tree pricing model16

Binomial options pricing model deals with the dynamics of the option's theoretical value for
discrete time intervals over the option's life. So that this model begin with a binomial tree of discrete
future possible underlying asset prices. Following the constructing of a riskless portfolio of an option
and asset a simple formula can be used to find the option price at each node in the tree. This value
can approximate the theoretical value calculated by Black- Scholes formula, to the desired degree of
precision17. The main advantage is the flexibility 18, these models are widely used by professional
option traders.

5.3 Monte Carlo models

Monte Carlo model uses simulation to generate random price paths of the underlying asset, each of
which results in a payoff of the option. The average of these payoffs can be discounted to yield an the
option expected value. It have to be noticed that, that despite its advantages, the use of a simulation
for American styled options is much more complex.

13
I.e. Gamma denotes the amount that the Delta will change if the market moves up/down 1 point.
14
The options introduced by the Balck-Scholes model are Plain vanilla, the classification of option will be dealt latter.
15
For the purpose of saving space, we will not describe in details each type of implementation, but the interested reader
can consult the literature from the references to know more information.
16
I.e. Trinominal tree princing model, etc.
17
Developed models are made by John Cox, Stephen Ross and Mark Rubinstein.
18
E.g., discrete future dividend payments can be modeled correctly at the proper forward time steps.
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5.4 Finite difference models

Usually, equations used to model the option are expressed as partial differential equations (PDE).
In this form, a finite difference model can be derived, and the valuation obtained. It exist a number of
implementations of finite difference methods for option valuation, as: explicit finite difference,
implicit finite difference and the Crank-Nicholson method. This approach is mathematically very
sophisticated, but is particularly useful where changes are assumed over time in model
inputs parameters19.

5.5 Other models

Also exist other numerical implementations that can be used to value options include finite
element methods, as so called short rate models20. These models also, admit closed-form equations,
and simulation-based modeling, with respective advantages and disadvantages.

6.Classifications of Options

There are many types of options, different according to their characteristics, however we can
distinguish them, by dividing in some major categories21:

1. Accordingly to the transactional right that option gives to the buyer:

- Put - an option which conveys the right to sell something

- Call - an option which conveys the right to buy something.

2. Accordingly to the financial market where the options are traded:

Exchange-traded (listed options) - Exchange traded options have standardized contracts, which are settled through a
settlement and clearing house with fulfillment guaranteed by the credit of the exchange. (include: stock options, bond
options, interest rate options, stock market index options, options on futures contracts and callable bull/bear contract )

Over-the-counter (dealer options) are traded between two private parties, and are not listed on a stock exchange. The
terms of an OTC option are unrestricted and may be individually tailored to meet any business need. (include: interest
rate options, currency options, and swaptions).

Other option types – namely private ones. (for example: real estate and employee stock options)

3. Accordingly to the Option style:

European – an option that may be exercised only on expiration.

American – an option that may be exercised on any trading day on or before expiration.

Bermudan – an option that may be exercised only on specified dates on or before expiration.

Barrier – any option with the general characteristic that the underlying security's price must pass a certain level or
"barrier" before it can be exercised.

Exotic option – any category of options that may include complex financial structures.

Plain Vanilla – any option that is not exotic.

19
E.g.: dividend yield, risk free rate, or volatility are not tractable in closed form
20
Developed for the valuation of interest rate derivatives, bond options and swaptions.
21
Of course, in financial world exist many different classifications of option, but for the purpose of space, we will not list
them in this paper, however, the interested reader, can consult the sources from the references.
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There are also more complicated instruments derived from the options such as Stradles, Strangles,
Caplets and Floorlets an so on.

7.Risks
Concerning the options, there exist different categories of risks, accordingly to the specifications
from the contract, the variables included in the calculation of options and accordingly to the type of
option.

Namely: liquidity risk, interest rate risk, volatility risk 22, Pin risk (when the underlying closes at or
very close to the option's strike value on the last day the option is traded prior to expiration, so that
the option seller may not know with sure if the option), Counterparty risk (the risk that the option
seller / buyer won't respect the contract). Also other categories of risk involved in options trade can
be described, accordingly to the option type.

8.Options Trade

Many options are created in standardized form and traded on options exchange to the general
public, while other over-the-counter options are customized to the desires of the buyer. The common
of trading options is via standardized that are listed by futures and options exchanges. Listings and
prices are registered and can be looked up by ticker symbol. The publishing is continuous for option
prices, so that an exchange enables different parties to engage in transactions. As an intermediary to
both sides of the transaction, the benefits the exchange provides to the transaction include the
fulfillment of the contract (backed by the credit of the exchange), counterparties are anonymous,
enforcement of market regulation to ensure fairness and transparency, and maintenance of orderly
markets. The over-the-counter options contracts are not traded on exchanges, but just by two
independent parties, avoiding an official exchange. For other type of options there are no markets so
that these can only be exercised by the original grantee or allowed to expire worthless.

8.1 Important issues

Settlement date must be clarified and to be concrete specified in the contract, because there are
cases when the expiration date is in the time of the weekend or on a holyday date. Of course there are
different Settlement and Clearing organizations, but these organizations also have some rules for
these case. For example, time convention, count basis. Generally there are 4 types of time count
basis: Actual/actual; Actual/360; Actual/365; European 30/360. Each of the giving the little different
result regarding the respective year fraction.

9.Practice

In practice, options valuation and implementation, the trade involve a lot of resources in monetary,
human and computer terms, plus there are legal terms which also must be fulfilled, especially
concerning tax obligations. In order to deal with options, it is necessary to have the qualified human
skills, all the information about considered financial factors that may affect the options have to be
available, good software and hardware are also a primary condition for option markets. The trader
must have some insurance in monetary terms for different cases of risk and have to comply with
regulations on the market23.

10.Importance of Options and Further Research

The respectives are highly sophisticated financial, derivative instruments, they are used for
different purposes: in order to gain profit, for hedging other instruments, for replication, in order to
22
Referred to the different parameters, accordingly to the option contract.
23
For the different options markets are different local requirements.
8
ensure other instruments, in order to fix a certain value, and so on. Investors, independent entities,
also local authorities use these instruments in their operations, for different purposes that fulfill the
economic needs. From other perspective we have the theoreticians, which use these instruments to
develop more sophisticated ones and different strategies concerning financial markets.

11. Critical Reflections

Options are not flexible instruments, they involve many resources in practice and qualified human
skills. Of course one usual element in the financial markets is the risk, but with option, this element is
much more emphasized. The transaction costs are very important and this factor erase all the
possibilities for small gains using this instrument. Market requirements combined with transaction
costs we can say that in one way select the investors and give only to sophisticated ones possibility
for option trade.

Conclusions
Options are financial instruments which are complicated and involve different categories of risks
and qualified resources, in order to deal with them. There exist different categories of options, and
new ones are developed, each of them have their own theoretical background and practical
requirements to fulfill. Concerning the theoretical background, the traders have on disposition also a
sensitivity analysis framework which can help them to manage options. There is a market financial
and legal trading frame to be fulfilled by participants. In general at present time, we assist to a
development of these instruments and increase in their use, however there are also situations of
options markets decline which emphasize the need to develop more these instruments.

Summary
In this paper, we analyze the option as an financial, derivative instrument. Basically, we define the
option as an tradablle contract which give to the buyer a transactional right with concrete parameters
that can be chaged in only in when contract is designed, and to the seller an obligation and monetary
premium. The short history concerning this instrument was provided, emphasizing the most
important year 1973, the famous Black–Scholes model used (together with other models) in the
valuation procedure. Some implementation models were also described: Binominal Trees, Analytic
techniques , Monte Carlo, Finite difference models . There are different types of options, some
uniformized, other customized, we proceed to the main categories, accordingly to the transactional
right achieved by the buyer, to the financial market were these instruments are traded and to the style
of respective. Option trading involves some risks linked to the contractual parameters. In practice,
there are some issues that must be taken into consideration (i.e. time count basis). The importance
and useof options is linked to their features, using them we can hedge, make profit, replicate other
instruments, insure some values, and so on. The critical reflection is that in practice, we need a lot of
resources to trade options plus there are transaction costs and there are limited number of financial
markets where respective are traded. We conclude that these instruments have a positive influence for
financial markets development, but there still is a need to develop them more.

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Pascucci, Andrea. PDE and Martingale Methods in Option Pricing. Berlin: Springer, 2011.

Options Trading – pedia.com (March 2012)

http://www.optiontradingpedia.com/

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James, P. Option Theory. The wiley Finance Series. Published by John Wiley and sons. Inc. USA 2003.

Rubash, K. Bradley Univeristy. Foster College of Business Administration. A Study of Option Pricing
Models. (March 2012)
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Investopedia (March 2012)

http://www.investopedia.com/

Chicago Board of Option Exchange (March 2012)

http://www.cboe.com/

Miller, F.P., Vandome, A.F., McBrewster, J. Option. VDM Publishing House Ltd., USA. 2009

The Option Industry Council (March 2012)

http://www.optionseducation.org/basics/whatis/

Bodie, Z. And co-authors. Investments, Irwin Inc., 1993.

Chen, N.F., Roll, R. And Ross, S. Theorie Financiere d’Evaluation. Economica. Paris, 1994, p. 187 – 214, 231
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Fama, E. and MacBeth, J.D. Risk, Return and Equilibrium: empirical Tests, journal of Political Economy.
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Lintner, J. Security Prices, Risk and Maximal Gains from Diversification, Journal of Finance, December 1965.

Wilmott, P. Derivative, Inginerie Financiară. Teorie şi Practică. Bucureşti. Editura Economică 2002.

Neftci. S.N. Principles of Financial Engineering. Elsevier Academic Press. USA.2004.

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