Asset-Liability and Liquidity Management

CHAPTER 4Option Valuation

An option is a class of financial contract whose value depends on the value of another financial instrument. The underlying instrument or element (e.g., interest rate) is usually called the reference or underlying. An option contract provides its owner with the right, but not the obligation, to take an action within some contractually specified parameters for a specific period of time in the future. For example, the action could be buying an asset at a certain price. Similar to other financial contracts, each option contract has two sides: one side buys the right to take the contractually specified action within a given time, commonly referred to as the long side, while the other side sells the right to the buyer and is contractually obligated to abide by the action taken by the buyer. This side is commonly referred to as the short side. Depending on the type of option contract, a premium may or may not be paid by the long side to the short side at the contract inception time. Taking the action granted by the option contract is commonly referred to as exercising the option. The contractual price in an option is known as the strike price or exercise price, the period of time that the contract is binding is known as the term, and the date when the contract ends is the maturity or expiration date. In an American option the holder may exercise the option at any day or some specific dates during the term of the contract. In the European option the holder ...