Question

What are some various options pricing models? Explain why some models work better than others and what determines that condition.

Answer 1

Types of Option pricing models:

1. Binomial Pricing Model- Under the binomial model, we find that the price of the underlying asset will either rise or fall over the duration. In view of the possible prices of the underlying asset and the impact price of the option, we can calculate the option payout under these scenarios, then discount these payouts and find the value of that option as of today.

2. Black Sholes Model- Mainly used for pricing European options and not American options due to their feature of being exercised earlier to maturity. This model is based on certain assumptions about the stock price distribution and economic environment.

3. Monte Carlo Simulation- A sophisticated method to price options by simulaing the future possible prices of a stock and then discount them to find expected option payoffs.

We can determine which option pricing model will be better suited by understanding the nature of the options and economic environment in a better way. For example, Black sholes model is a go-to pricing option for maximum valuers owing to its predictibility of output. However, this can only be used for European options. The Monte carlo simulation model is generally used to value options having multiple sources of uncertainties like exchange rates, stock prices, interest rates etc. Also, factors like quantum of option exercise history, quantum of stock valuation periods, availablity of financial resources to spend on running the chosen valuation model etc should be taken into account while choosing the correct pricing model.