DEFINITION of 'Option Pricing Theory'

Any model- or theory-based approach for calculating the fair value of an option.

The most commonly used models today are the Black-Scholes model and the binomial model. Both theories on options pricing have wide margins for error because their values are derived from other assets, usually the price of a company's common stock. Time also plays a large role in option pricing theory, because calculations involve time periods of several years and more. Marketable options require different valuation methods than non-marketable ones, such as those given to company employees.

BREAKING DOWN 'Option Pricing Theory'

How stock options should be valued has become an important debate in the past few years because U.S. companies are now required to expense the cost of employee stock options on their earnings statements. For many young companies trading on the stock exchanges today, this expense will be considerable no matter what valuation methods are used. The need for consistent and accurate treatment of this increasing expense provides incentive for the creation of new and innovative solutions to option pricing theory.

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