OVME Option Pricing Models

David Frank and Changrong Cui

Quantitative Finance Development

Bloomberg L.P.

Auguse 3, 2015

Keywords. OVME.

First published December 10, 2012.

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Description of OVME Option Pricing Models

The methods used to price an equity option are best categorized by considering the choices made
for what are, in principle, three independent decisions: what assumptions to make regarding the
Stock Process; what assumptions to make regarding payment of future Dividends; and having
made choices for the first two, what numerical Solution Method to use. In the function OVME,
the choices on the screen for “Style”, “Exercise”, and “Model” together determine the stock process,
dividend treatment, and solution method.

For “Style” choice “Vanilla”, the following table shows the decisions made in these three areas for
each combination of OVME choices. For other “Style” choices, the Stock Process and Dividends
column still apply, but the Solution Method may differ depending on the particular “Style”,
and some “Model” choices may be unavailable. More detailed explanations of the different stock
processes, dividend treatments, and solution methods follow the table.

Stock Solution
Exercise Model Process Dividends Method
European BS Continuous BS Continuous Formula
European BS Discrete BS Discrete Type 2 PDE
European Local Vol LV Discrete Type 2 PDE
European Trinomial BS Discrete Type 1 Trinomial Tree
American BS Continuous BS Continuous PDE
American BS Discrete BS Discrete Type 2 PDE
American Local Vol LV Discrete Type 2 PDE
American Trinomial BS Discrete Type 1 Trinomial Tree

Explanatory notes for the table:

Stock Process: The stock process BS refers to the stock process in the standard Black-Scholes
model, with time-varying parameters; and LV refers to the stock process in the local volatility
model, essentially, the Black-Scholes model extended by making the volatility a function of both
time and stock price.

Dividends: The discrete dividend treatments are of two types: in Discrete Type 1, the present
value of dividends is subtracted from the initial stock price and the remaining portion is viewed as
the uncertain part, subject to diffusion without subsequent jumps; in Discrete Type 2, the entire
initial stock price is subject to diffusion, and jumps are introduced at each discrete dividend date.
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Solution Methods: The solution methods used are of three types: analytic solutions, or formulas;
partial differential equations (PDEs) solved numerically using a discretization over a grid; and
trinomial trees, which can be viewed as a specialization of the PDE solution method.

Applicability of Models for Vanilla Options: For “Style” choice “Vanilla”, some of the models
are available only in certain cases. This may be due to the treatment of dividends in the model and
its applicability to individual equity or stock index options, or due to the ability of a given model to
handle early exercise. We indicate the availability of each ”Model” choice here, based on whether
the underlying is a stock or stock index, and whether the exercise is European or American:

Model Index/Stock European/American Exercise

BS Continuous Both Both
BS Discrete Both Both
Local Vol Both Both
Trinomial Both Both

The rest of this document proves more detail on the various stock processes, dividend treatments,
and solution methods, as well as some comments on differences between options on individual
equities and options on stock indices.
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Stock Processes

Notation: We use the following notation in the rest of this section:

St Stock price at time t

r The interest rate, possibly time-varying
q The continuous dividend rate, possibly time-varying
σ The volatility, possibly time-varying
Di , ti The discrete dividend amount Di , going ex-dividend at time ti
dWt A standard Brownian motion

The stock process model, often referred to as, simply, “the model”, describes the assumed possible
paths of future stock prices and the probabilities of those paths. The most common such model
for equities is Black-Scholes with continuous proportional dividends, where the stock process under
the risk-neutral measure is given by the stochastic differential equation

dSt = [r − q] St dt + σ St dWt

This model for stock price movement assumes stock price paths are continuous, changes in log-
price over any time interval are normally distributed, and the changes in price over one or more
disjoint intervals are independent. A further refinement, adding absolute discrete dividends, adds
a downward jump in the stock price at known dividend times ti to the above process:

St+i = St−i − Di

A second choice is the local volatility model. This is a generalization of Black-Scholes, where the
volatility σ is assumed to be a deterministic function of both time and future stock price. Under
this model, the process followed by the stock price is

dSt = [r − q] St dt + σ(t, St )St dWt

where σ(t, St ) is called the “local volatility”. The advantage of using this more general functional
form for σ is that the model can now be calibrated to match market option prices at multiple
strikes at a single expiration.

Dividend Treatments

Dividend payment model: This describes the assumed behavior of stock dividends in the future.
The choices can be organized over two dimensions:
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(i) timing: timing can be discrete, whereby lump payments are made at specified points in time,
the way real dividends are paid; or continuous, where dividends accrue over time like interest on a
bank account.

(ii) determination of dividend amount: dividend amounts can be either absolute dividends, where
the dividends are assumed known upfront, and don’t vary depending on future stock price behavior;
or proportional, where the dividends paid at a discrete time point or over a continuous interval
are proportional to the future stock price. Absolute dividends are probably more appropriate for
nearby dividend payments, where the dividends are more certain; and proportional dividends are
more appropriate for dividends further in the future, where the stock price and dividend will likely
move in tandem.

The discrete dividend handling in the OVME models appears in two forms, as described above:
Discrete Type 1, where the present value of dividends is subtracted from the initial stock price
and the remaining portion is viewed as the uncertain part, subject to diffusion without subsequent
jumps; and Discrete Type 2, where the entire initial stock price is subject to diffusion, and jumps
are introduced at each discrete dividend date. For an article contrasting the two approaches to
handling discrete dividends, see the Bloomberg Magazine article ”Valuing Options on Dividend-
Paying Stocks”, appearing in the July 1998 issue of the magazine. (This article can be accessed
on the Bloomberg terminal under {MAG<GO>}, select ”Search Previous Issues”, and use as the
search date ”07/98”).

Numerical Solution Methods

Given the parameters provided (strike price, stock price, volatility, etc.), there are various solution
methods possible. For some combinations of stock process model, dividend payment model, and
deal structure, a closed form solution (or simply, a formula) can be used to calculate the price.
This is sometimes referred to as an analytic solution. Usually, if an analytic solution is available, it
will be used, unless the user explicitly requests another solution method. Other solution methods
include tree solvers (binomial, trinomial, etc.), and pde solvers.

Distinctions Between Equity Options and Stock Index Options

Equity options and stock index options have much in common, but generally differ most in that
a stock index will pay a dividend stream that tends to resemble a continuous payment stream
while individual equities pay a dividend stream that is quite obviously not continuous. While this
distinction is to some extent arbitrary, as even an index pays discrete dividends corresponding to
those of its components, the distinction nevertheless may make some solution methods impractical
for one type or the other. This is why some ”Model” choices are restricted to options on individual
stocks.