Option Pricing Theory

Filed Under » ,
Dictionary Says

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.
Investopedia Says

Investopedia explains '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.

Related Definitions

  • Black Scholes Model

    A model of price variation over time of financial instruments such as stocks that can, among other things, be used to determine the price of a European call option. The model assumes ...
    Read More »
  • Black's Model

    A variation of the Black-Scholes model that allows for the valuation of options on futures contracts.
    Read More »
  • Implied Volatility - IV

    The estimated volatility of a security's price. In general, implied volatility increases when the market is bearish and decreases when the market is bullish. This is due to the common ...
    Read More »
    • Binomial Option Pricing Model

      An options valuation method developed by Cox, et al, in 1979. The binomial option pricing model uses an iterative procedure, allowing for the specification of nodes, or points in time, ...
      Read More »
    • Financial Modeling

      The process by which a firm constructs a financial representation of some, or all, aspects of the firm or given security. The model is usually characterized by performing calculations, ...
      Read More »
    • Options Backdating

      The process of granting an option that is dated prior to the date that the company granted that option. In this way, the exercise price of the granted option can be set at a lower price ...
      Read More »
    • Tree Diagram

      A diagram used in strategic decision making, valuation or probability calculations. The diagram starts at a single node, with branches emanating to additional nodes, which represent ...
      Read More »
    • Decision Tree

      A schematic tree-shaped diagram used to determine a course of action or show a statistical probability. Each branch of the decision tree represents a possible decision or occurrence. The ...
      Read More »
    • Gamma Pricing Model

      An equation for determining the fair market value of a European-style option when the price movement on the underlying asset does not resemble a normal distribution. The gamma pricing ...
      Read More »

Articles Of Interest

Partner Links