CHAPTER 3 Valuing Vanilla Options

Options and options-embedded instruments trade in abundance and diversity on both the over-the-counter (OTC) and exchange-traded markets globally. Since the underlyings of these options span a multitude of asset classes (e.g., equity, commodity, interest rate, and currency—just to name a few), it is not surprising to expect the option landscape to be a very complex one. Despite the complexity of the landscape, all options can be categorized as either vanilla or exotic:

  • Vanilla options refer to options that allow owners to transact (i.e., buy or sell) the asset underlying the option for a pre-specified price at a pre-specified time(s) in the future.
  • Exotic options refer to options that are not vanilla options (e.g., buy the asset for the average price of the asset realized during the life of the option).

Regardless of the nature of the option (vanilla or exotic), all option owners have the ability to exercise at

  • One prespecified time (or option maturity).1
  • Any time up to and including the option maturity.2
  • Limited times up to and including the option maturity.3

The reader is referred to Hull (2012) or any good introductory finance book for further descriptions of these options. For the ease of discussion, unless otherwise mentioned, I will henceforth restrict my discussion to European-style options.

One of the most common and widely traded European-style options is the one linked to the S&P 500 index that trades under the symbol SPXW on ...

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