Options Pricing Theory Essay

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Options Pricing Theory Acct 301 Clint Helveston October 3, 2014 One of the foundations in Financial Mathematics is the option pricing theory, which Ross has described as “the most successful theory not only in finance, but in all of economics.” (Ross, Eattwell, Milgate, & Newman, 1987) Options pricing theory attempts to determine the value of an option. The majority of options pricing theories have margins of error that are fairly high as the values are determined from other underlying securities. Because of this, mostly analytical traders and institutions will use option pricing theories in order to participate in the markets. This paper discusses the historical significance of option pricing theory and its metamorphosis through modern day markets. (Ross, Eattwell, Milgate, & Newman, 1987) A “call” or “put” option gives the holder the right to “buy” or “sell” the underlying asset by a certain expiration date and at a certain price, which is called the strike price. If the option can only be exercised on expiration it is knows as European style, however if the option can be exercised on any trading day before expiration it is referred to as American style. A call option gives the holder the right to buy 100 shares of a security at a fixed price and the seller the obligation to sell the stock at the fixed price. Owners of call options want the price of the stock to increase. If the price of the stock increases above the strike price, holders can either exercise the option or sell for a profit. The holder of a put option has the right to sell 100 shares of a security at a fixed price, and the writer of a put option has the obligation to buy the stock if exercised. (Nasdaq, 2014) A call option is said to be in the money when the underlying security's price is higher than the strike price. A put option is in-the-money if the spot

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