Factors Determining Option Value

1. Exercise price and the share (underlying asset)

price
2. Volatility of returns on share
3. Time to expiration
4. Interest rates
 Limitations of DCF Approach
2

The DCF approach does not work for options

because of the difficulty in determining the
required rate of return of an option. Options are
derivative securities. Their risk is derived
from the risk of the underlying security. The
market value of a share continuously changes.
Consequently, the required rate of return to a
stock option is also continuously changing.
Therefore, it is not feasible to value options
using the DCF technique.
 Model for Option Valuation
3

 Simple binomial tree approach to option

valuation.
 Black-Scholes option valuation model.