IMPLIED SPOT AND FORWARD RATES
CHAPTER 4 STATED
that an option’s time value is determined in three steps:
1. A rational distribution of prices for the underlying security is projected out to an option’s future exercise date.
2. The option’s intrinsic value on the future date is measured relative to the underlying bond’s projected price distribution.
3. Any resulting intrinsic value is present-valued over the intervening period and expressed as the option’s time value.
The binomial-tree option model employs many of the principles highlighted in Chapter 4’s coin-toss example. The chief objective of the model is to generate a distribution of future prices for an option’s underlying security based on observable market conditions. It is essential ...