(107)---OPTIONS AND THEIR VALUATION

Options and Their Valuation

Options mean things to different people. It may refer to choice or alternative or privilege or opportunity or preference right.

To have options is normally regarded good. One is considered unfortunate without any options. Options are valuable since they provide protection against unwanted, uncertain happenings. They provide alternatives to bail out from a difficult situation. Options can be exercised on happening of certain events.

Options may be explicit or implicit. When you buy insurance on your house, it is an explicit option that will protect you in the event there is a fire or a theft in your house. If you own share of a company, your liability is limited. Limited liability is an implicit option to default on the payment of debt.

Options have assumed considerable significance in finance. They can be written on any asset, including shares, binds, portfolios, stock indices, currencies excreta. They are quite useful in risk management. How are options defined in finance? What gives value to options? How are they valued?

Options

In a broad sense, an option is a claim without any liability. It is a claim contingent upon the occurrence of certain conditions.

Depending on when an option can be exercised, it is classified in one of the following two categories.

• European option
  When an option is allowed to be exercised only on the maturity date, it is called a European option.
• American option
  When the option can be exercised any time before its maturity, it is called American option.