CHAPTER 15
Option Valuation
Just what is an option worth? Actually, this is one of the more difficult
questions in finance. Option valuation is an esoteric area of finance since it
often involves complex mathematics. Fortunately, just like most options
professionals, you can learn quite a bit about option valuation with only
modest mathematical tools. But no matter how far you might wish to delve
into this topic, you must begin with the Black-Scholes-Merton option pricing
model. This model is the core from which all other option pricing models
trace their ancestry.
The previous chapter introduced to the basics of stock options. From an economic standpoint,
perhaps the most important subject was the expiration date payoffs of stock options. Bear in mind
that when investors buy options today, they are buying risky future payoffs. Likewise, when investors
write options today, they become obligated to make risky future payments. In a competitive financial
marketplace, option prices observed each day are collectively agreed on by buyers and writers
assessing the likelihood of all possible future payoffs and payments and setting option prices
accordingly.
In this chapter, we discuss stock option prices. This discussion begins with a statement of the
fundamental relationship between call and put option prices and stock prices known as put-call parity.
We then turn to a discussion of the Black-Scholes-Merton option pricing model. The Black-ScholesMerton option pricing model is widely regarded by finance professionals as the premiere model of
stock option valuation.
2 Chapter 15
(margin def. put-call parity Thereom asserting a certain parity relationship between
call and put prices for European style options with the same strike price and
expiration date.
15.1 Put-Call Parity
Put-call parity is perhaps the most fundamental parity relationship among option prices.
Put-call parity states that the difference between a call option price and a...