Pricing Options

An option buyer has the right but not the obligation to exercise on the seller. The worst that can happen to a buyer is the loss of the premium paid by him. His downside is limited to this premium, but his upside is potentially unlimited. This optionality has a value expressed in terms of the option price. Just lies in other free markets. it is the supply and demand in the secondary market that drives the price of an option. There are various models that help us get close to the true price of an options.

Pricing Index Options

Under the assumption of the Black-Scholes Options Pricing options should be valued in the same way as ordinary options on common slock, the assumption being that investors can purchase, without cost, the underlying stocks in the exact to replicate the index, that is, stocks are infinitely divisible and the index follows a process such that the continuously compounded returns distribution of the index is distributed. To use the Black-Scholes formula for index options we must, he make adjustments for the dividend payments, replacing the current index value S in the model with Se, where q is the annual dividend yield and T is the time to expiration in years.

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