Friday, January 1, 2010


Bi nominal Model for Option Value

In previous posts we have enumerated factors that influence the value of an option. Let us examine the methods of valuing options next.

We shall illustrate only the valuation of stock (share) options. We shall first discuss simple binomial tree approach to option valuation and later the Black schools option valuation model.
Inadequacy of Discounted cash flow analysis

As we discussed that assets are valued using the discounted cash flow approach. The value of an asset equals the discounted value of its cash flows. Is not the value of an option its present value?

The discounted cash flow 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 discounted cash flow technique.

Options give the holder a right over the favorable outcomes of an asset. These outcomes are, however, highly risky. But a buyer pays much less for an option than the price of the asset. The buyer makes a very small investment in high risk outcomes. Options are more risky than the underlying asset.

A simple binomial approach to option valuation

Suppose you own a share that has a current price of 150$. Its price at the end of one year has two possibilities: either 100$ or 300$. Assume that you buy a call option on the share with an exercise price of 200$. At the end of the year, you will exercise your option if the share price is 300$ and the value of the option you will be 300$-100$ = 100$. You will forgo your call option if the share price is 100$, and the value of option will be zero.

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