VARIABLES THAT IMPACT THE PRICING OF OPTIONS

VARIABLES THAT IMPACT THE PRICING OF OPTIONS 5

VARIABLESTHAT IMPACT THE PRICING OF OPTIONS

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July1, 2014.

PricingOption

Infinancial investments, options refer to derivative contracts thatgive the holders the right and not obligation to sell or buy anyinstrument at a specified price before or on specified future date.The seller holds an obligation to sell or buy the instrument if theoption is viable while the holder (buyer) does not have an obligationto exercise such option. In this option trading, the buyer has to paythe seller some premium for this contract. The valuation of theoption price has been a topic of academic and finance research sincethe nineteenth century. There are two types of Option prices timevalue and the intrinsic value. Pricing option trading has manybenefits options enhance or protect the investor’s portfolio infalling or rising and in the neutral markets (Coxet al. 1979).

However,it is important to have knowledge of factors that may alter theoption value. These factors are underlying price of the instrument,strike price, expiry time and the intrinsic value of an option. Theunderlying price determines the option price option premium changeswith price of underlying assets. When the strike price is closer tomarket price, the rate of change is high and verse versa. Strikeprice refers to the price that is exchanged if the buyer exercisesthe option of the contract. As such, strike price is critical indetermining the contract price option in this case the exerciseprice does not get affected. Time of expiry is another essentialfactor that affects the option prices more time means moreuncertainty and higher chances of stock price fluctuations andbenefit to one party in the contract. In this case, more time callsfor a higher premium and the option price will be in the measure totime left before the contract expires. For example, if an investmenttrader buys an instrument that is four months to expiration, it willbe more costly than a five days option.

Inaddition, if an investor buys an option that is four months away tothe expiry date and then sells it when it is five days to expiry,there would be a loss in premium. Rate of interest also determinesthe option price the higher the interest rate, the higher thevariation of call option price and put option price. Furthermore,expected dividends on underlying stock assets have a significantimpact on the future pricing of options. There are two major methodsof pricing options these are the black-scholes and the binomialmodels (Coxet al. 1979).

TheBlack-Scholes

Thismode of pricing applies mathematical formulae to derive derivativeprice for investment instruments. It is a widely used model inEuropean stock market for put or calls options that do not havedividends. The model was used to derive equations that estimated theprices of options over a period. The underlying idea behind the modelwas hedging selling or buying underlying instrument in the right wayto minimize risks. The model assumes a geometrical distribution. Theblack –schole’s formula has an exceptional parameter its abilityto determine the future of the underlying instrument.

Themerits of this method of option pricing are that it enhances aquicker calculation of several option prices, gives usefulestimations it is reversible and forms the basis of other refinedmodels. However, the model has a limitation in that it cannotaccurately price options and only calculates option price at specifictimes only. It uses the assumptions of instant yield liquidity risksand cost less trading that are difficult to hedge. In addition, thismodel assumes that there are continuous trading and time which yieldgap risks. It also assumes a stationary process in option tradingthis could lead to yield volatility risks and become difficult tohedge (Coxet al. 1979).

Binomialmodels

Inthis pricing model, a numerical method is used to provide optionvaluation. It utilizes the model of varying prices of underlyingassets overtime and do not have a closed form it breaks downexpiration time in time intervals. Using this model, a tree of stockprices is created towards the expiration date. In this way, themodel assumes that stock prices might change move up or down. Ingeneral, the model creates a binomial distribution that representspossible ways in which the stock prices would change before expiry.

Themethod is widely used in different conditions where other models arenot applicable because the model is open to describing underlyingassets over time as opposed to single time frame. It is relativelysimpler and readily implementable through computer software. Althoughit is computationally slower than the Black -Scholes model, it ismore accurate and more dependable when calculating long time optionsand with securities that have payments for dividends. The model has alimitation in that the method is less practical with options thathave complicated features. In addition, this model is time consumingas a large number of simulation steps is involved (Coxet al. 1979).

References

Cox,J. C.Ross,S. A.Rubinstein,M.(1979). &quotOption pricing: A simplified approach.&quot Journalof Financial Economics7(3): 229.