(Created 2009-08-11.)

OPTION THEORY | EXTF40 |

**Aim**

The aim of the course is to provide knowledge of the valuation and pricing of option contracts.

*Knowledge and understanding*

For a passing grade the student must

· understand the basic functions of forward and option contracts,

· understand the theoretical pricing of forwards and options using the binomial model and the BlackScholes model,

· understand the difference between the assumptions needed to price forward contracts and option contracts,

· explain how underlying variables affect the price of forwards and options,

· explain how Monte Carlo simulation can be used to price option contracts,

· generalise the knowledge to types of options that are not treated in the course.

*Skills and abilities*

For a passing grade the student must

· use forward and option contracts for risk management purposes,

· apply different price setting methods,

· evaluate the assumptions of various price setting methods,

· analyse the price sensitivity of an option portfolio to the variables that determine option prices,

· carry out a Monte Carlo simulation to determine option prices.

*Judgement and approach*

For a passing grade the student must

**Contents**

The course deals with the theoretical valuation of European and American call and put options. Under the assumption of an arbitrage free market, the course identifies the boundaries within which option prices must be during the duration of the option.Using additional assumptions regarding the development of the underlying asset over time (its stochastic process), the exact price of the option is derived, using either the binomial model or the Black-Scholes model. The main aim of the course is to establish an understanding of standardised option contracts.

**Literature**

Hull, John C (2008): Options, Futures and Other Derivatives, seventh edition, Prentice-Hall

Supplementary material