Finance and Financial Markets

Third Edition

by Keith Pilbeam

Chapter 15 - Option Pricing

Find an overview and useful learning resources below to accompany Finance and Financial Markets chapter fifteen.

Chapter Introduction

In the previous chapter we examined some of the basic issues relating to options and looked at possible return profiles. In this chapter we look at the more complex question of option pricing. In particular we examine the factors that determine the price of an option, first intuitively and then analytically using the famous Black–Scholes option pricing formula which was put forward in a classic paper by Black and Scholes (1973). Although there have been many refinements to the Black–Scholes formula it has become one of the most famous equations of economics and is widely used by practitioners to determine appropriate option premiums. We also consider the relationship between call and put premiums via the put–call parity condition.

Learning Objectives

In this chapter you will learn about:
  • ​The difference between intrinsic value and time value
  • The factors that determine call and put premiums
  • How to price call options using the Black–Scholes option pricing formula
  • How to calculate historical volatility and the difference between historical
    Expected and implied volatility
  • Importance of the ‘Greeks’ in measuring the sensitivity of option prices
  • How to price put options from call option premiums using put–call parity

Further Reading

Haug, E.G. (2007) The Complete Guide to Option Pricing Formulas, 2nd edn, McGraw-Hill.

Hull, J.C. (2008) Options, Futures and Other Derivatives, 7th edn, Prentice-Hall.

Kolb, R.W. and Overdahl J. (2007) Futures, Options and Swaps, 5th edn, Basil Blackwell.

Natenberg, S. (2009) Basic Option Volatility Strategies: Understanding Popular Pricing Models, Marketplace Books.

Multiple Choice Questions

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