Chapter 6. Option Pricing
When you want to estimate the price of fruit salad, you average the prices of the fruit the mixture contains. In a similar vein, I thought of the option formula as a prescription for estimating the price of a hybrid by averaging the known market prices of its ingredients.
—Emanuel Derman1
Option pricing is built on arbitrage. Yet perhaps you don’t think of fruit salad when you think of arbitrage or option prices. Complex problems are best understood when distilled to their basic building blocks. Option pricing can be approached the same way. An option can indeed be valued by averaging the prices of its underlying components. And arbitrage sets boundaries on the ultimate result. This chapter identifies the essential ingredients ...
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