# CHAPTER 5

# Option Pricing Theory and Models

**I**n general, the value of any asset is the present value of the expected cash flows on that asset. This chapter considers an exception to that rule when it looks at assets with two specific characteristics:

- The assets derive their value from the values of other assets.
- The cash flows on the assets are contingent on the occurrence of specific events.

These assets are called options, and the present value of the expected cash flows on these assets will understate their true value. This chapter describes the cash flow characteristics of options, considers the factors that determine their value, and examines how best to value them.

## BASICS OF OPTION PRICING

An option provides the holder with the right to buy or sell a specified quantity of an underlying asset at a fixed price (called a strike price or an exercise price) at or before the expiration date of the option. Since it is a right and not an obligation, the holder can choose not to exercise the right and can allow the option to expire. There are two types of options—call options and put options.

### Call and Put Options: Description and Payoff Diagrams

A call option gives the buyer of the option the right to buy the underlying asset at the strike price or the exercise price at any time prior to the expiration date of the option. The buyer pays a price for this right. If at expiration the value of the asset is less than the strike price, the option is not exercised and expires worthless. ...