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Modern Portfolio Theory and Investment Analysis, 9th Edition by William N. Goetzmann, Stephen J. Brown, Martin J. Gruber, Edwin J. Elton

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23

Option Pricing Theory

The markets for options are among the fastest-growing markets for financial assets in the United States. While option trading is not new, it experienced a gigantic growth with the creation of the Chicago Board of Options Exchange in 1973. The listing of options meant more orderly and thicker markets for these securities.

The growth in option trading has been accompanied by a tremendous interest among academics and practitioners in the valuing of option contracts. In this chapter we discuss alternative types of options, examine the effect of certain characteristics on the value of options, and present explicit models for valuing options.

TYPES OF OPTIONS

An option is a contract entitling the holder to buy or sell a designated security at or within a certain period of time at a particular price. There are a large number of types of option contracts, but they all have one element in common: the value of an option is directly dependent on the value of some underlying security. Options represent a claim against the underlying security and thus are often called contingent claim contracts. The two least complex options are called puts and calls. These are the most widely traded options. In addition, most other options either can be valued as combinations of puts and calls or can be valued by the methodology developed to value puts and calls. Consequently, we begin this section with a discussion of puts and calls, and then we discuss other types of options and ...

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