Option Pricing

In general, the value of any asset is the present value of the expected cash flows on that asset. In this section, we will consider an exception to that rule when we will look at assets with two specific characteristics:

• They derive their value from the values of other assets.

• The cash flows on the assets are contingent on the occurrence of specific events. These assets are called options, and the present value of the expected cash flows on these assets will understate their true value. In this section, we will describe the cash flow characteristics of options, consider the factors that determine their value and examine how best to value them.

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