Analysis of Asset Allocation

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Options: Pricing models
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As we have seen in the basic components of the option's price, the value of option is made of intrinsic and extrinsic value.

At maturity, the option value is only made of intrinsic value. Valuing an option means valuing the remaining time to maturity together with expected changes in the underlying prices.

The probability of asset price changes is usually referred to as volatility and is unknown. As it is unknown, the volatility must be estimated. Doing so gives rise to a number of different option pricing models.

The most known models are:

  • For European style options

    • Black-Scholes.

    • Jump-Diffusion (Merton).

    • Constant Elasticity (Cox).

    • Displaced Diffusion (Rubinstein).

    • Stochastic Volatility (Hull and White).

    • Compound (Geske).

  • For American style options

    • Standard binomial (Cox-Ross-Rubinstein).

    • Edgeworth implied binomial trees (Rubinstein).

In the next pages, we will focus on Black-Scholes and Standard binomial (Cox-Ross-Rubinstein).


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