![]() ![]() This theoretical value measures the probability of buying and selling the assets as if there was a single probability for everything in the market. However, we neither assume that all the investors in the market are risk-neutral, nor the fact that risky assets will earn the risk-free rate of return. The risk-neutral probability is the probability that the stock price would rise in a risk-neutral world. There are no arbitrage opportunities in the market.The current value of an asset is equal to its expected payoff discounted at the risk-free rate.There are two main assumptions behind this concept: The risk-neutral probability is a theoretical probability of future outcomes adjusted for risk. Risk-neutral Probabilityīefore we start discussing different option pricing models, we should understand the concept of risk-neutral probabilities, which are widely used in option pricing and may be encountered in different option pricing models. The above-mentioned classification of options is extremely important because choosing between European-style or American-style options will affect our choice for the option pricing model. American style options can be exercised anytime between purchase and expiration date.European style options may be exercised only at the expiration date.Options may also be classified according to their exercise time: Put is an option contract that gives you the right, but not the obligation, to sell the underlying asset at a predetermined price before or at expiration day.Call is an option contract that gives you the right, but not the obligation, to buy the underlying asset at a predetermined price before or at expiration day.There are two major types of options: calls and puts. What is an Option?Ī formal definition of an option states that it is a type of contract between two parties that provides one party the right, but not the obligation, to buy or sell the underlying asset at a predetermined price before or at expiration day. Therefore, option pricing models are powerful tools for finance professionals involved in options trading. Knowing the estimate of the fair value of an option, finance professionals could adjust their trading strategies and portfolios. In other words, option pricing models provide us a fair value of an option. The theoretical value of an option is an estimate of what an option should be worth using all known inputs. Option Pricing Models are mathematical models that use certain variables to calculate the theoretical value of an option. Updated DecemWhat are Option Pricing Models? ![]()
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