Definition
Option pricing theory establishes the theoretical fair value of options based on underlying price, strike, time to expiration, volatility, risk-free rate, and dividends. The Black-Scholes model (1973) and binomial model are the foundational approaches. Option pricing relies on the concept of risk-neutral valuation and the ability to construct riskless hedging portfolios.
lightbulb Example
A call option on a $100 stock: strike $105, 3 months to expiration, volatility 25%, risk-free rate 4%. Black-Scholes prices it at $3.50, reflecting the probability of the stock exceeding $105 at expiration, time value, and the cost of carrying the hedge.
verified_user Key Points
- Black-Scholes and binomial models are foundational
- Based on risk-neutral pricing and hedging
- Five key inputs: price, strike, time, volatility, rate
- Put-call parity links calls and puts