Call Option Price Formula
Call option price formula for the single period binomial option pricing model:
c = (πc+ + (1-π) c-) / (1 + r)
π = (1+r-d) / (u-d)
"π" and "1-π" can be called the risk neutral probabilities because these values represent the price of the underlying going up or down when investors are indifferent to risk.
r = The risk free rate
The same formula is applied for put options.
Steps for solving the value of a call option with the single period binomial model:
Calculate "u" and "d".
Calculate "π" (note: the risk free rate should be provided)
Combine "π" with c+ and c- to value the call.
NOTE: This can be repeated for the put option.
Test Tip:
Whenever pricing options on an exam question, it is a good idea to give your answer the laugh test; in other words, does the answer you are calculating make sense given the data provided.
For example a call that is deep out of the money should be relatively inexpensive; whereas a call that is deep in the money should be close to its intrinsic value plus a small time premium.
- CFA Level 2: Derivatives Part 2 – Introduction
- Introduction to Options
- Synthetic Options and Rationale
- One Period Binomial Option Pricing Model
- Call Option Price Formula
- Binomial Interest Rate Options Pricing
- Black-Scholes-Merton (BSM) Option Pricing Model
- Black-Scholes-Merton Model and the Greeks
- Dynamic Delta Hedging & Gamma Related Issues
- Estimating Volatility for Option Pricing
- Put-Call Parity for Options on Forwards
- Introduction to Swaps
- Plain Vanilla Interest Rate Swap
- Equity Swaps
- Currency Swaps
- Swap Pricing vs. Swap Valuing
- Pricing and Valuing a Plain Vanilla Interest Rate Swap
- Pricing and Valuing Currency Swaps
- Pricing and Valuing Equity Swaps
- Swaps as Theoretical Equivalents of Other Derivatives
- Swaptions and their Valuation
- Swap Credit Risk and Swap Spread
- Interest Rate Derivatives - Caps and Floors
- Credit Default Swaps (CDS)
- Credit Derivative Trading Strategies