OPTION PRICING

Option Pricing

Option Pricing

Introduction

This paper intends to discuss that how slight increases in the nature of the underlying factors that are critical in determining the option price tend to impact the overall price of a call option. The Black Scholes method is essentially made to cater the call option of European market. The purpose of this paper is to make the reader aware about the different aspects of key determinants of the Black Scholes option pricing model. Black Scholes option pricing model is usually applied in the cases where the limiting distribution is done according to the normal distribution (Chriss, 1997 Pp. 45-70). The prevalence of normal distribution remains the most important aspect of applying Black Scholes option pricing. Further, the Black Scholes pricing model is assumed to be designed for the purpose of valuing the European options particularly those which are protected by dividends. The model was presented by Black and Scholes with a clear assumption that the pricing process is continuous without any jumps in the asset prices (Johnson & Shanno, 1987 Pp. 143-151). The paper will discuss the significance of Black Scholes option pricing model for European options and an underlying increase in the value of the determinants.

Discussion

In order to discuss that how slight increases in the nature of the underlying factors that are critical in determining the option price tend to impact the overall price of a call option; it remains extremely important to explore about the determinants of the Black Scholes option pricing model. The Black Scholes method is essentially made to cater the call option of European market and the underlying critical factors are associated with the importance of investment market components in the European Market. The Black Scholes option pricing model is basically intended to value the European options which are protected by dividends. The value of call under the Black Scholes model is calculated through (Black & Scholes, 1973 Pp. 637-654);

Value of call = S N (d1) - K e-rt N(d2)

Value of Determinants in Black Scholes Model and Price of Call Option

The Black Scholes model is assumed to be the first option pricing model in the field of finance. This model is still the most popular and most commonly used model for pricing option. The basic assumption of Black Scholes option pricing model is that the stock does not pay any dividends within the life of option. Moreover, the European exercise terms are used in the Black Scholes model. The efficiency of market is also an important determinant of Black Scholes Pricing Model. There are no commissions within the model and there is an assumption that interest rates remain constant. The most important assumption of the model is that returns are normally distributed (Black & Scholes, 1973 Pp. 637-654).

The formula presented by Black Scholes to calculate the value of call options as discussed above tends to be impacted by several different determinants. The option price is basically impacted by five different options which are stock price, strike price, volatility, risk ...