Variables Determining Option Prices

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Table of Contents

Introduction
Variables determining option prices
Conclusion
References

Introduction

An option is a term used in finance to define a contract in which the buyer has the right, but not a compulsion, to purchase or dispose the underlying instrument whether before, or on a specified date at a particular strike price (Zapart, 2003). However, if the buyer fails to exercise that right, the seller is obligated to buy or sell the underlying instrument. To determine the value of an option, various methods are used. These include the Black-Scholes and the Binomial. These two models account for a number of variables and explain how they impact an option’s price. This paper aims to identify these variables based on the two models.

Variables determining option prices

One of the variables that influence the valuation of an option, common to the two models, is volatility. Using the Black-Scholes model, the value of an option is assumed to exist as a function of the volatility of a share’s value. As such, where the volatility is high, the premium on an option will follow the same path. In Binomial model, the price of an option is understood to be a function of volatility and time. However, unlike in the Black-Scholes model, a large volatility does not result into a larger option’s price. Rather, the amount of time is factored in thus determining the true value of an option. According to Chance (2008), the larger the volatility, and the more the amount of time, the higher the possibility of an option’s value being high.

A further variable, which is commonly used by the two models to determine the price of an option, is the prevalent risk-free rate of interest. The major assumption with the Black-Scholes model is that a higher present free interest rate brings rise to an elevated amount of lost interest. This means that a lower option’s premium will have to be offered to compensate for the forgone interest. In other words, the option will be provided at a lower price to recover the lost interest.

The way in which the free interest rate is treated using the Binomial method is entirely different. According to Zapart (2003), the model assumes that the rate of interest is frequently fluctuating. When a fall in the rates is experienced, there is a huge likelihood that the price of an option will rise. Conversely, if the rates fall, the value is expected to lower.

The two pricing models also hold out that the time to expiry plays a key role in determining the value of an option. When using both methods, the intrinsic value of an option is determined by calculating the difference between the strike price and the present price of the stock. Where the strike price exceeds that of the current share, it means that the option does not carry any intrinsic value, and vice versa. The level of the intrinsic value defines the nature of the option’s price. A lower intrinsic value implies a declining option’s price while a higher one means a high option’s value (Chance, 2008).

Conclusion

In conclusion, it is evident that a set of variables tends to determine the price or the value of an option. In this paper, two option pricing models, the Black-Scholes and the Binomial model, have been assessed to document these variables and their respective impacts. As it has been identified, among the most essential variables include volatility, the prevalent risk-free rate of interest, and the time to expiry. While each model treats these variables distinctively, they come to the same conclusions about their impacts on option price.

References

Chance, D. M. (2008). A Synthesis of Binomial Option Pricing Models for Lognormally Distributed Assets. Journal of Applied Finance, 12(5), 38-54.

Zapart, C. A. (2003). Beyond Black–Scholes: a neural networks-based approach to options pricing. International Journal of Theoretical and Applied Finance, 6(05), 469-489.

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Variables Determining Option Prices

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