Models of Financial Mathematics, MTMM.00.

203

Options
An option is a contract giving it's holder the right to receive in the future a payment which
amount is determined by the behaviour of the stock market up to the moment of executing the
contract. In general, these contracts are classified according to several characteristics
including possible execution times (a fixed date vs a time interval), the number of underlying
assets and how the value of option depends on the underlying asset prices (depending on the
price at the execution time vs a path dependent value of the asset prices).
The term ‘underlying asset’ has quite general scope. Apart from typical assets such as stocks,
commodities or foreign currency, there are options on stock indices, interest rates, or even on
the snow level at a ski resort. Some underlying assets may be impossible to buy or sell. The
option is then cleared in cash in a fashion which resembles settling a bet.
More detailed concepts
A call option is the right to buy an asset at an established price at a certain time. Call option is
an agreement or contract by which at a definite time in the future, known as the expiry date,
and the holder of the option may purchase from the option writer an asset known as the
underlying asset for a definite amount known as the exercise price or strike price.
A put option is the right to sell an asset at an established price at a certain time. Put option is
an agreement or contract by which at a definite time in the future, known as the expiry date,
and the holder of the option may sell to the option writer an asset known as the underlying
asset for a definite amount known as the exercise price or strike price.
An European option may only be exercised at the end of its life on the expiry date, an
American option may be exercised at any time during its life up to the expiry date.
Six factors affect the price of a stock option:
the current stock price S;
the strike price K;
the time to expiration T − t where T is the expiration time and t is the current time;
the volatility of the stock price σ;
the risk-free interest rate r; and
the dividends expected during the life of the option.

Another slightly simpler financial instrument is a future, which is a contract to buy or sell an
asset at an established price at a certain time. In a futures contract the writer must buy (or sell)
the asset to the holder at the agreed price at the prescribed time. The underlying assets
commonly traded on options exchanges include stocks, foreign currencies, and stock indices.
For futures, in addition to these kinds of assets the common assets are commodities such as
minerals and agricultural products. In this text we will usually refer to options based on
stocks, since stock options are easily described, commonly traded and prices are easily found.
Options can be in the money, at the money or out of the money. An in-the-money option
would lead to a positive cash flow to the holder if it were exercised immediately. Similarly, an
at-the-money option would lead to zero cash flow if exercised immediately, and an out-of-the-
money would lead to negative cash flow if it were exercised immediately. If S is the stock
price and K is the strike price, a call option is in the money when S > K, at the money when S
= K and out of the money when S < K. Clearly, an option will be exercised only when it is in
the money.
An option is determined by its payoff, which for a European call is S(T) − K if S(T) > K and 0
otherwise. This payoff is a random variable, contingent on the price S(T) of the underlying on
the exercise date T. This explains why options are sometimes referred to as contingent claims.

50

40

Payoff Function
for European Put
30

20
K = 90

10

-10
40 60 80 100 120 140 160
Recall the Black – Scholes PDE

V 1  2V V
   S  2  r  S 
2 2
 r V  0 .
t 2 S S
The end condition for this equation is
V(T, S) = p(S), 0 < S < ∞ ,
Where p = p(t,S) is payoff function. The fair price of European call at t = 0 is V(0,S(0)). The
writer of this option can avoid the risk at t = T if he has
V (t , S (t ))
 (t ) 
S
Stocks at every moment t.
The main approach for estimating the parameters of the market model is fitting the market
model to historical data.

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