Equity and Index Options Explained

7

Pricing Options

GLOSSARY

(Option) market-maker: Market professional specialising in the provision of two-way prices in options.

Cost-of-carry: The interest rate cost of holding a long stock position.

As discussed in Chapter 4, options are by no means a modern-day invention. From Phoenician grain traders to Yankee and Confederate financiers, options have played a key role in the management of price risk. In short, options have been around for a very long time. However, it was only as recently as 1973 that the first accurate method of valuing and pricing options was invented. Robert Merton, an American economist, enhanced the work of two fellow academics, Fischer Black and Myron Scholes, to come up with the first “option pricing model”; the ubiquitous “Black & Scholes”. The significance of this pioneering mathematical work was subsequently recognised in 1997 by the award of a “Nobel Prize”, a fact that underlines both its value and its complexity. All of which begs a question. If the first method of accurately pricing options was not developed until 1973, how were options valued before that? How were options evaluated by Thales or the advisers to General Lee? The best way to answer this is with another question, a little closer to home (or home contents!).

Remember the everyday example of a put option from Chapter 1? How do we price our home insurance? Presumably, we contact a number of insurance companies and choose the cheapest and/or most suitable policy. We make a comparison ...