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# FORWARD CONTRACT

Payoffs
The value of a forward position at maturity depends on the relationship between the delivery price (K) and the underlying price (ST) at that time.   For a long position this payoff is: fT = ST − K For a short position, it is: fT = K − ST 

How a forward contract works

Example of how forward prices should be agreed upon
Continuing on the example above, suppose now that the initial price of Andy's house is \$100,000 and that Bob enters into a forward contract to buy the house one year from today. But since Andy knows that he can immediately sell for \$100,000 and place the proceeds in the bank, he wants to be compensated for the delayed sale. Suppose that the risk free rate of return R (the bank rate) for one year is 4%. Then the money in the bank would grow to \$104,000, risk free. So Andy would want at least \$104,000 one year from now for the contract to be worthwhile for him - the opportunity cost will be covered.

Spot - forward parity
Main article: Forward price See also: Cost of carry and convenience yield For liquid assets ("tradeables"), spot-forward parity provides the link between the spot market and the forward market. It describes the relationship between the spot and forward price of the underlying asset in a forward contract. While the overall effect can be described as the cost of carry, this effect can be broken down into different components, specifically whether the asset:    pays income, and if so whether this is on a discrete or continuous basis incurs storage costs is regarded as  an investment asset, i.e. an asset held primarily for investment purposes (e.g. gold, financial securities);  or a consumption asset, i.e. an asset held primarily for consumption (e.g. oil, iron ore etc.)

Investment assets
For an asset that provides no income, the relationship between the current forward (F0) and spot (S0) prices is

F0 = S0erT
where r is the continuously compounded risk free rate of return, and T is the time to maturity. The intuition behind this result is that given you want to own the asset at time T, there should be no difference in a perfect capital market between buying the asset today and holding it and buying the forward contract and taking delivery. Thus, both approaches must cost the same in present value terms. For an arbitrage proof of why this is the case, see Rational pricing below. For an asset that pays known income, the relationship becomes:   Discrete: F0 = (S0 − I)e Continuous: F0 = S0e
rT

(r − q)T

where is the present value of the discrete income at time t1 < T, and q%p.a. is the continuous dividend yield over the life of the contract. The intuition is that when an asset pays income, there is a benefit to holding the asset rather than the forward because you get to receive this income. Hence the income (I or q) must be subtracted to reflect this benefit. An example of an asset which pays discrete income might be a stock, and example of an asset which pays a continuous yield might be a foreign currency or a stock index. For investment assets which are commodities, such as gold and silver, storage costs must also be considered. Storage costs can be treated as 'negative income', and like income can be discrete or continuous. Hence with storage costs, the relationship becomes:   Discrete: F0 = (S0 + U)e Continuous: F0 = S0e
rT

(r + u)T

is the convenience yield over the life of the contract.a. which means a [1] higher convenience yield. The opposite is true when high inventories exist. and are referred to as the convenience yield. this implies a greater chance of shortage. Hence. for example crude oil or iron ore. Relationship between the forward price and the expected future spot price Main articles: Normal backwardation and Contango . Thus. is the storage cost where it is proportional to the price of the commodity. c. for consumption assets. Thus. However. all of the costs and benefits above can be summarised as the cost of carry. The intuition here is that because storage costs make the final price higher. Users of these consumption commodities may feel that there is a benefit from physically holding the asset in inventory as opposed to holding a forward on the asset.a. and is hence a 'negative yield'. These benefits include the ability to profit from temporary shortages and the [1] ability to keep a production process running. Cost of carry The relationship between the spot and forward price of an asset reflects the net cost of holding (or carrying) that asset relative to holding the forward. Since the convenience yield provides a benefit to the holder of the asset but not the holder of the forward. If users have low inventories of the commodity. it is important to note that the convenience yield is a non cash item. where c = r − q + u − y. the spot-forward relationship is:   Discrete storage costs: F0 = (S0 + U)e Continuous storage costs: F0 = S0e (r − y)T (r + u − y)T where y%p.where is the present value of the discrete storage cost at time . and u%p.   Discrete: F0 = (S0 + U − I)e cT (r − y)T Continuous: F0 = S0e . it can be modelled as a type of 'dividend yield'. but rather reflects the market's expectations concerning future availability of the commodity. we have to add them to the spot price. Consumption assets Consumption assets are typically raw material commodities which are used as a source of energy or in a production process.

if the speculators expect to profit. . Thus. where K is the delivery price at maturity Thus. it must be the case that the expected future spot price is greater than the forward price. In other words. the natural hedgers of [3][4] a commodity are those who wish to sell the commodity at a future point in time. hedgers will collectively hold a net short position in the forward market. There are a number of different hypotheses which try to explain the relationship between the current forward price. F0 and the expected future spot price. and thus will accept losing money on their forward contracts. Hedgers are interested in reducing risk.The market's opinion about what the spot price of an asset will be in the future is the expected future [1] spot price. a key question is whether or not the current forward price actually predicts the respective spot price in the future. the expected payoff to the speculator at maturity is: E(ST − K) = E(ST) − K. E(ST) − K > 0 E(ST) > K E(ST) > F0. The economists John Maynard Keynes and John Hicks argued that in general. Hence. are interested in making a profit. as K = F0 when they enter the contract This market situation. who must therefore hold a net long position. The other side of these contracts are held by speculators. where E(ST) > F0. E(ST). is referred to as normal backwardation. if speculators are holding a net long position. Speculators on the other hand. Since forward/futures prices converge with the spot price at maturity (see basis). and will hence only enter the contracts if they expect to make money. Thus.

A short forward contract means that the investor owes the counterparty the stock at time T. Then we have two possible cases. go to the bank and get a loan with amount St at the continuously compounded rate r. you will see that if there are finite stocks/inventory. is positive. with this money from the bank. Case 2: Suppose that Ft. This is called a cash and carry arbitrage because you "carry" the stock until maturity.. r(T − t) r(T − t) Extensions to the forward pricing formula Suppose that FVT(X) is the time value of cash flows X at the contract expiration time T. buy one unit of stock for St.T because the buyer receives ST from the investor. Specifically.T > Ste trades at time t: r(T − t) .T = Ste . Consequently. . Then an investor can do the reverse of what he has done above in case 1. At time T the investor can reverse the trades that were executed at time t. enter into one short forward contract costing 0. where E(ST) < F0. The sum of the inflows in 1. 2. It would depend on the elasticity of demand for forward contracts and such like. and 3. The inflow to the investor is − Ste r(T − t) . which by hypothesis. The opposite situation.T − Ste .' and 2. and r is the continuously compounded r(T − t) rate. The initial cost of the trades at the initial time sum to zero. This is an arbitrage profit. then the forward price at a future time T must satisfy Ft.normal backwardation implies that futures prices for a certain maturity are increasing over time. To prove this. the investor 1.T < Ste . suppose not. or costs of maintaining the asset. 2. contango implies that futures prices for a certain maturity are [5] falling over time.T. we have a contradiction. 3. and assuming that the nonarbitrage condition holds. But if you look at the convenience yield page. Then an investor can execute the following 1. ' repays the loan to the bank. is referred to ascontango. Rational pricing If St is the spot price of an asset at time t. The cash inflow to the investor is now Ft. Case 1: Suppose that Ft. the reverse cash and carry arbitrage is not always possible. 2. The forward price is then given by the formula: The cash flows can be in the form of dividends from the asset. and mirroring the trades 1. Likewise. ' settles the short forward contract by selling the stock for Ft.' equals Ft.

If these price relationships do not hold.T = (St − It)er(T − t) Where It is the time t value of all cash flows over the life of the contract. there is an arbitrage opportunity for a riskless profit similar to that discussed above. One implication of this is that the presence of a forward market will force spot prices to reflect current expectations of future prices.the relationship between forward and spot prices is driven by interest rates. . For perishable commodities. the forward price for nonperishable commodities. see forward price. securities or currency is no more a predictor of future price than the spot price is . For more details about pricing. arbitrage does not have this The above forward pricing formula can also be written as: Ft. As a result.

Some U. that would be about 77% annualized. The low margin requirements of futures results in substantial leverage of the investment. in contrast to other securities Initial Margin (which is set by the Federal Reserve in the U. Calls for margin are usually expected to be paid and received on the same day.S. but rather it is a security deposit. A futures account is marked to market daily. Settlement . However. can set it above that. Markets). however. The broker may set the requirement higher. After the position is closed-out the client is liable for any resulting deficit in the client’s account. The Initial Margin requirement is established by the Futures exchange. the exchanges require a minimum amount that varies depending on the contract and the trader. if he does not want to be subject to margin calls. a margin call will be issued to bring the account back up to the required level. exchanges also use the term ―maintenance margin‖. representing the amount of their trading capital that is being held as margin at any particular time. Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in his margin account. the broker will make a margin call in order to restore the amount of initial margin available. Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchange’s perceived risk as reflected in required margin. which in effect defines by how much the value of the initial margin can reduce before a margin call is made. most non-US brokers only use the term ―initial margin‖ and ―variation margin‖. margin called for this reason is usually done on a daily basis. A trader. of course.physical versus cash-settled futures . Margin-equity ratio is a term used by speculators.S. However. Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. The Annualized ROM is equal to (ROM+1)(year/trade_duration)-1. in times of high volatility a broker can make a margin call or calls intra-day. For example if a trader earns 10% on margin in two months. ROM may be calculated (realized return) / (initial margin). If not. Often referred to as ―variation margin‖.If a position involves an exchange-traded product. the amount or percentage of initial margin is set by the exchange concerned. In case of loss or if the value of the initial margin is being eroded. If the margin drops below the margin maintenance requirement established by the exchange listing the futures. the broker has the right to close sufficient positions to meet the amount called by way of margin. but may not set it lower. Margin in commodities is not a payment of equity or down payment on the commodity itself.

and convenience yields. in a shallow and illiquid market. Here the price of the futures is determined by today's supply and demand for the underlying asset in the futures. differential borrowing and lending rates. the market clearing price for the futures may still represent the balance between supply and demand but the relationship between this price and the expected future price of the asset can break down. for a simple. as expressed by supply and demand for the futures contract. Here. which is simple supply and demand for the asset in the future. In a deep and liquid market. as the arbitrage mechanism is not applicable. will be found by compounding the present value S(t) at time t to maturity T by the rate of risk-free return r. F(t).this scenario there is only one force setting the price. supply and demand would be expected to balance out at a price which represents an unbiased expectation of the future price of the actual asset and so be given by the simple relationship. or may be freely created. or in a market in which large quantities of the deliverable asset have been deliberately withheld from market participants (an illegal action known ascornering the market). in practice there are various market imperfections (transaction costs. restrictions on short selling) that prevent complete arbitrage. non-dividend paying asset. dividends. . the value of the future/forward. Arbitrage arguments Arbitrage arguments ("Rational pricing") apply when the deliverable asset exists in plentiful supply. dividend yields. Thus. the forward price represents the expected future value of the underlying discounted at the risk free rate—as any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away. the futures price in fact varies within arbitrage boundaries around the theoretical price. with continuous compounding This relationship may be modified for storage costs. Pricing via expectation When the deliverable commodity is not in plentiful supply (or when it does not yet exist) rational pricing cannot be applied. By contrast. In a perfect market the relationship between futures and spot prices depends only on the above variables. Thus. . or.

lead. orange juice. Inactive market in Baltic Exchange shipping. Soybeans. gold. government interest rates and private interest rates.) . TOPIX Futures) Tokyo Commodity Exchange TOCOM Tokyo Financial Exchange . currency and currency indexes.(Euroyen Futures.)  IntercontinentalExchange (ICE Futures Europe) . CAC 40. (LIFFE had taken over London Commodities Exchange ("LCE") in 1996). FTSE 100. Milk). etc.energy and metals: crude oil. Index (Dow Jones Industrial Average).TFX .which absorbed Euronext into which London International Financial Futures and Options Exchange or LIFFE (pronounced 'LIFE') was merged. aluminum and palladium .softs: grains and meats. Cattle. This innovation led to the introduction of many new futures exchanges worldwide. Various Interest Rate derivatives (including US Bonds). AEX index. Soy Products. Metals (Gold. gasoline. energy. RNP Futures) London Metal Exchange . Index (NASDAQ.expanded to include metals. Agricultural (Corn.liffe). heating oil. tin and steel IntercontinentalExchange (ICE Futures U. Pork. propane. Butter. S&P. copper.metals: copper. coffee. Deutsche Terminbörse (now Eurex) and the Tokyo Commodity Exchange (TOCOM). Index futures include EURIBOR. nickel. cotton.S. heating oil.Currencies. sugar  New York Mercantile Exchange CME Group. silver. natural gas. zinc. SpotNext RepoRate Futures)    Osaka Securities Exchange OSE (Nikkei Futures. equities and equity indexes.SAFEX Sydney Futures Exchange Tokyo Stock Exchange TSE (JGB Futures. OverNight CallRate Futures.formerly New York Board of Trade softs: cocoa. Silver). natural gas and unleaded gas  NYSE Euronext .formerly the International Petroleum Exchange trades energy including crude oil. there are more than 90 futures and futures options exchanges worldwide trading to include: [6]  CME Group (formerly CBOT and CME) -.      South African Futures Exchange . platinum. coal. aluminium. such as the London International Financial Futures Exchange in 1982 (now Euronext. Exchanges Contracts on financial instruments were introduced in the 1970s by the Chicago Mercantile Exchange (CME) and these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. Today. Wheat.

November (X) 2010 (0) contract. In other words. Who trades futures? Futures traders are traditionally placed in one of two groups: hedgers.SGX . .KRX Singapore Exchange . who have an interest in the underlying asset (which could include an intangible such as an index or interest rate) and are seeking to hedge out the risk of price changes.   Dubai Mercantile Exchange Korea Exchange .into which merged Singapore International Monetary Exchange (SIMEX)  ROFEX . the third character identifies the month and the last character is the last digit of the year. The first two characters identify the contract type. who seek to make a profit by predicting market moves and opening a derivative contract related to the asset "on paper". while they have no practical use for or intent to actually take or make delivery of the underlying asset.Rosario (Argentina) Futures Exchange Codes Most Futures contracts codes are four characters. the investor is seeking exposure to the asset in a long futures or the opposite effect via a short futures contract. Third (month) futures contract codes are             January = F February = G March = H April = J May = K June = M July = N August = Q September = U October = V November = X December = Z Example: CLX0 is a Crude Oil (CL). and speculators.

. Investors can either take on the role of option seller/option writer or the option buyer. COT-Report or simply COTR. and a call is the option to buy a futures contract. Option sellers are generally seen as taking on more risk because they are contractually obligated to take the opposite futures position if the options buyer exercises his or her right to the futures position specified in the option. the option strike price is the specified futures price at which the future is traded if the option is exercised. Futures are often used since they are delta one instruments. options are traded on futures. The Commission has the right to hand out fines and other punishments for an individual or company who breaks any rules. and under contract can fine companies for different things or extend the fine that the CFTC hands out. This type of report is referred to as the 'Commitments of Traders Report'. A put is the option to sell a futures contract. The price of an option is determined by supply and demand principles and consists of the option premium. We describe a futures contract with delivery of item J at the time T:  There exists in the market a quoted price F(t.  The price of entering a futures contract is equal to zero.T). Although by law the commission regulates all transactions. [9] Futures contract regulations All futures transactions in the United States are regulated by the Commodity Futures Trading Commission (CFTC). These reports are released every Friday (including data from the previous Tuesday) and contain data on open interest split by reportable and non-reportable open interest as well as commercial and non-commercial open interest. sometimes called simply "futures options".In many cases. Definition of futures contract Following Björk[10] we give a definition of a futures contract. or the price paid to the option seller for offering the option and taking on risk. which is known as the futures price at time t for delivery of J at time T. For both. The CFTC publishes weekly reports containing details of the open interest of market participants for each market-segment that has more than 20 participants. each exchange can have its own rule. an independent agency of the United States government. namely Black's formula for futures. Calls and options on futures may be priced similarly to those on traded assets by using an extension of the BlackScholes formula.

Futures are margined daily to the daily spot price of a forward with the same agreed-upon delivery price and underlying asset (based on mark to market). This means that entire unrealized gain (loss) becomes realized at the time of delivery (or as what typically occurs. Margining For more details on Margin.assuming the parties must transact at the underlying currency's spot price to facilitate receipt/delivery. The fact that forwards are not margined daily means that. for example.Thus futures have significantly less credit risk. More typical would be for the parties to agree to true up. The counterparty for delivery on a futures contract is chosen by the clearing house. the spread in exchange rates is not trued up regularly but. this differs from futures which get 'trued-up' typically daily by a comparison of the market value of the future to the collateral securing the contract to keep it in line with the brokerage margin requirements. or can simply be a signed contract between two parties. the time the contract is closed prior to expiration) . Exchange versus OTC Futures are always traded on an exchange. being over-the-counter. They may transact only on the settlement date. and have different funding. so if the buyer of the contract incurs a drop in value.  In the case of physical delivery. due to movements in the price of the underlying asset. Again. Forwards do not have a standard. rather. an unrealized gain (loss) can build up. whereas forwards can be unique. the forward contract specifies to whom to make the delivery. This true-ing up occurs by the "loss" party providing additional collateral. see Margin (finance). The result is that forwards have higher credit risk than futures. being exchange-traded. In a forward though. a large differential can build up between the forward's delivery price and the settlement price. the daily variation margin settlement guidelines for futures call for actual money movement only above some insignificant amount to avoid wiring . In most cases involving institutional investors. and in any event. the shortfall or variation margin would typically be shored up by the investor wiring or depositing additional cash in the brokerage account. Thus:  Futures are highly standardized. every quarter. and that funding is charged differently. it builds up as unrealized gain (loss) depending on which side of the trade being discussed. whereas forwards always trade over-the-counter.

rather than an individual party. Thus. the risk of a forward contract is that the supplier will be unable to deliver the referenced asset. while the forward's spot price converges to the settlement price. This means that the "mark-to-market" calculation would requires the holder of one side of the future to pay \$2 on day 51 to track the changes of the forward price ("post \$2 of margin"). potentially building up a large balance. strictly speaking. while for a forward contract the gain or loss remains unrealized until expiry. On day 51. where no daily true-up takes place in turn creates credit risk for forwards. a European-style derivative: the total gain or loss of the trade depends not only on the value of the underlying asset at expiry. to the holder of the other side of the future. not the gain or loss over the life of the contract. that futures contract costs \$90. except for tiny effects of convexity bias (due to earning or paying interest on margin). Simply put. Example: Consider a futures contract with a \$100 price: Let's say that on day 50. the daily futures-settlement failure risk is borne by an exchange. further limiting credit risk in futures. a futures contract with a \$100 delivery price (on the same underlying asset as the future) costs \$88. but holders of futures experience that loss/gain in daily increments which track the forward's daily price changes.000. however. This means that there will usually be very little additional money due on the final day to settle the futures contract: only the final day's gain or loss. due to the path dependence of funding. for both assets the gain or loss accrues over the holding period. the loss party wires cash to the other party. via margin accounts. The threshold amount for daily futures variation margin for institutional investors is often \$1. That is. this may be reflected in the mark by an allowance for credit risk. may pay nothing until settlement on the final day. In addition. This difference is generally quite small though. The margining of futures eliminates much of this credit risk by forcing the holders to update daily to the price of an equivalent forward purchased that day. while under mark to market accounting. The situation for forwards. a futures contract is not. So. . but also on the path of prices on the way. however. Note that.back and forth small sums of cash. for a futures this gain or loss is realized daily. but not so much for futures. or that the buyer will be unable to pay for it on the delivery date or the date at which the opening party closes the contract. This money goes. futures and forwards with equal delivery prices result in the same total loss or gain. A forward-holder.

bond options and other interest rate options stock market index options or. also called "dealer options") are traded between two private parties. and are not listed on an exchange.. currency cross rate options.Types The Options can be classified into following types: Exchange-traded options  Exchange-traded options (also called "listed options") are a class of exchange-traded derivatives. particularly in the U. However. and are settled through a clearing housewith fulfillment guaranteed by the credit of the exchange. Option types commonly traded over the counter include: 1. Exchange-traded options include:       stock options. Bermudan option – an option that may be exercised only on specified dates on or before expiration. . options on swaps or swaptions. and 3. Since the contracts are standardized. which are awarded by a company to their employees as a form of incentive compensation. commodity options. many of the valuation and risk management principles apply across all financial options. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. and prepayment options are usually included in mortgage loans. Other option types Another important class of options. at least one of the counterparties to an OTC option is a well-capitalized institution. Option styles Main article: Option style Naming conventions are used to help identify properties common to many different types of options. for example real estate options are often used to assemble large parcels of land. In general.S. are employee stock options. simply. These include:    European option – an option that may only be exercised on expiration. Exchange traded options have standardized contracts. interest rate options 2. Other types of options exist in many financial contracts. American option – an option that may be exercised on any trading day on or before expiry. accurate [5][6] pricing models are often available. index options and options on futures contracts callable bull/bear contract Over-the-counter  Over-the-counter options (OTC options.

   Barrier option – any option with the general characteristic that the underlying security's price must pass a certain level or "barrier" before it can be exercised. particularly in relation to the current market price of the underlying (in the money vs. and an estimate of the future volatility of the underlying security's price over the life of the option. These models are implemented using a [8] variety of numerical techniques. out of the money).k. Thorp. the application of the model in actual options trading is clumsy because of the assumptions of continuous (or no) dividend payment. In general. and a constant interest rate. Nevertheless. More sophisticated models are used to model the volatility smile. the Black-Scholes model is still one of the most important methods [11] and foundations for the existing financial market in which the result is within the reasonable range. constant volatility. The most basic model is the Black-Scholesmodel.. varying both for time and for the price level of the underlying security. Black-Scholes Main article: Black–Scholes Following early work by Louis Bachelier and later work by Edward O. By employing the technique of constructing a risk neutral portfolio that replicates the returns of holding an option. The following are some of the principal valuation techniques used in practice to evaluate option contracts. it has been observed that market implied volatility for options of lower strike prices are typically higher than for higher strike prices. suggesting that volatility is stochastic. the cost of holding a position in the underlying security. the model generates hedge parameters necessary for effective risk management of option holdings. More advanced models can require additional factors. Stochastic volatility models Main article: Heston model Since the market crash of 1987. While the ideas behind the Black-Scholes model were ground-breaking and eventually led to Scholes and Merton receiving the Swedish Central Bank's associated Prize for Achievement in [10] Economics (a.a. the Nobel Prize in Economics). standard option valuation models depend on the following factors:      The current market price of the underlying security. [7] Valuation models Main article: Valuation of options The value of an option can be estimated using a variety of quantitative techniques based on the concept of risk neutral pricing and using stochastic calculus. Black and Scholes produced a [9] closed-form solution for a European option's theoretical price. such as an estimate of how volatility changes over time and for various underlying price levels. At the same time. Exotic option – any of a broad category of options that may include complex financial structures. the strike price of the option. the time to expiration together with any restrictions on when exercise may occur. Stochastic volatility models have . including interest and dividends. Vanilla option – any option that is not exotic. or the dynamics of stochastic interest rates. Fischer Black and Myron Scholes made a major breakthrough by deriving a differential equation that must be satisfied by the price of any derivative dependent on a non-dividend-paying stock.

Monte Carlo models Main article: Monte Carlo methods for option pricing For many classes of options. and American options can be modeled as well as European ones.g. Binomial models are widely used by professional option traders. the binomial model is considered more accurate than Black-Scholes because it is more flexible. The resulting solutions are readily computable. This value can approximate the theoretical value produced by Black Scholes. The average of these payoffs can be discounted to yield [15] an expectation value for the option. Note though. discrete future dividend payments can be modeled correctly at the proper forward time steps. each of which results in a payoff for the option. particularly when fewer time-steps are modelled. Analytic techniques In some cases.been developed including one developed by S. down or stable path. Rather than attempt to solve the differential equations of motion that describe the option's value in relation to the underlying security's price. allowing for an up. e. See also: SABR Volatility Model [12] Model implementation Further information: Valuation of options Once a valuation model has been chosen. as are their "Greeks". Stephen Ross and Mark [13] [14] Rubinstein developed the original version of the binomial options pricing model. traditional valuation techniques are intractable because of the complexity of the instrument. to the desired degree of precision.L.. The model starts with a binomial tree of discrete future possible underlying stock prices. Once expressed in this form. a finite difference model can be derived. a Monte Carlo model uses simulation to generate random price paths of the underlying asset. while other stochastic volatility models require complex numerical [12] methods. Binomial tree pricing model Main article: Binomial options pricing model Closely following the derivation of Black and Scholes. Heston. In these cases. it is less commonly used as its implementation is more complex. One principal advantage of the Heston model is that it can be solved in closed-form. TheTrinomial tree is a similar model. a Monte Carlo approach may often be useful. using simulation for American styled options is somewhat more complex than for lattice based models. there are a number of different techniques used to take the mathematical models to implement the models. although considered more accurate. John Cox. Finite difference models Main article: Finite difference methods for option pricing The equations used to model the option are often expressed as partial differential equations (see for example Black–Scholes PDE). It models the dynamics of the option's theoretical value for discrete time intervals over the option's life. that despite its flexibility. However. one can take the mathematical model and using analytical methods develop closed form solutions such as Black-Scholes and the Black model. and . By constructing a riskless portfolio of an option and stock (as in the Black-Scholes model) a simple formula can be used to find the option price at each node in the tree.

A trinomial tree option pricing model can be shown to be a simplified application of the explicit finite difference method. Γ.5 and volatility falls to 23. For instance. with XYZ currently trading at \$48. Other models Other numerical implementations which have been used to value options include finite element methods. or some combination of these – that are not tractable in closed form. This technique can be used effectively to understand and manage the risks associated with standard options. the risks associated with holding options are more complicated to understand and predict. various short rate models have been developed for the valuation of interest rate derivatives. Although the finite difference approach is mathematically sophisticated. bond options and swaptions. 0. XYZ stock rises to \$48.022).5%. Γ. implicit finite difference and the Crank-Nicholson method.439. or volatility. Additionally. lattice-based. one can estimate the risk inherent in holding an option by calculating its hedge parameters and then estimating the expected change in the model inputs. at any point in time. The corresponding price sensitivity formula for this portfolio Π is: Example A call option expiring in 99 days on 100 shares of XYZ stock is struck at \$50.0631. allow for closed-form. 9. We can calculate the estimated value of the call option by applying the hedge parameters to the new model inputs as: .the valuation obtained. The hedge parameters Δ. and −0. the change in the value of an option can be derived from Ito's lemma as: where the Greeks Δ. unlike traditional securities. dσ and dt. These. However. κ and θ are the standard hedge parameters calculated from an option valuation model. Thus. the theoretical value of the option is \$1. A number of implementations of finite difference methods exist for option valuation. the return from holding an option varies non-linearly with the value of the underlying and other factors. respectively. risk free rate. With future realized volatility over the life of the option estimated at 25%. κ. In general. and dS. by offsetting a holding in an option with the quantity − Δ of shares in the underlying. Risks As with all securities. and simulation-based modelling. dσ and dt are unit changes in the underlying's price. such as Black-Scholes. it is particularly useful where changes are assumed over time in model inputs – for example dividend yield. dS. with corresponding advantages and considerations. the underlying's volatility and time. θ are (0. respectively.6.89. a trader can form a delta neutral portfolio that is hedged from loss for small changes in the underlying's price. similarly. trading options entails the risk of the option's value changing over time. Therefore. including: explicit finite difference. Assume that on the following day. provided the changes in these values are small.