Running Head: An Overview of Options

An Overview of Options
Ramprakash Subharanjani
GRGSMS

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Financial Derivatives

A financial derivative product is a contract in which the buyer of the contract has the
right to buy or sell an underlying asset at a predetermined price at a future date. There are
basically four types of financial derivative products. These are futures, forwards, options and
swaps. Whereas futures and forwards are simple, options and swaps are much more complex.
As the financial markets evolved, so did the complexity of the financial derivative products.
Understanding the basics of these products is essential to price the derivatives and to trade
them. The objective of this essay is to study about the basics of options and the problems in
pricing the options, so that better trading decisions can be taken.
Basics of Options
An option is a contract to buy or sell a specific underlying asset. There are basically
two types of options viz. the call option (right to buy) and the put option (right to sell). These
options are commonly traded in share markets, currency markets, commodity markets etc.
The options contracts are extensively used to hedge an investment. They are also used to
speculate on arbitrage opportunities.
Types of Options
There are many ways to classify the options. On the basis of expiry, the options can be
classified as European options or American options. The European options can be exercised
only at maturity whereas the American options can be exercised anytime until maturity.
These two types are called as plain vanilla options. There are also other types of options
called as exotic options. According to John Hull (2012), Exotic Options are non-standard
options which are traded over the counter.

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Option Pricing

The price of the options contract is called as the premium. The premium of the
options contract is determined by the supply and demand for the underlying asset quoted in
the options contract. But a theoretical derivation of the option premium value is difficult,
since supply and demand cannot be easily determined in real time. Black-Scholes option
pricing model is one of most famous option pricing model that is helpful in calculating the
premium value. But Black-Scholes model is based on various assumptions of ideal
conditions which are hardly prevalent in real markets. One of the assumptions is that the
volatility of the underlying asset follows a normal distribution curve and is the same as the
volatility of the option prices. But in reality, both the volatilities have different values.
Consequently the market prices of options are so very different from the model prices
rendering the theory invalid. In order to rectify this problem, Heston (1993) suggested the
replacement of normality in Black-Scholes equation with the stochastic volatility. Although
this method also failed to fully account for the market prices of options, it paved the way for
numerous other approximations to the Black-Scholes Equation. Subsequently more
successful models were developed.
Conclusion
Derivatives pricing is fast becoming the most important concept in financial
institutions as new financial products are structured and introduced on a regular basis.
Although the Black-Scholes option pricing method does not accurately predict option prices,
they can still be used as a guide for investment decision making. This model is still used as
the basis for numerous research works to arrive at the accurate option prices.

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References

John C. Hull, (2012). Options, futures and other derivatives (8th ed.). Pearson
education limited publication.
Steven L. Heston, (1993). A closed form solution for options with stochastic volatility
with applications to bonds and currency options. The review of financial studies, 6(2), 327343.