Advanced Modelling in Finance Using Excel and VBA

Chapter 9. Introduction to Options on Equities

The importance of options cannot be overstated. Since the publication of Fischer Black and Myron Scholes' initial paper on the valuation of options in 1973, a plethora of financial products has been developed and traded throughout the world. In addition, the theory has been extended to cover not only equities but bonds and even real assets.

A call option is the right to buy an asset at an agreed exercise price. A put option is the right to sell an asset at a given exercise price. European options allow exercise only at the expiry of the option. American options allow exercise at or before the expiry date. Whereas the Black–Scholes pricing formula values European options, most traded options are American options.

The Options part of the book is structured differently from the Equities part. This chapter contains an overview of the concepts and theory which will be drawn on in the following four chapters. The objective of option pricing is to value these derivatives and subsequent chapters tackle different approaches to valuation. The appropriateness of different approaches in part depends on the type of option considered and whether the Black–Scholes formula or an extension can be applied. If not, there are alternative numerical methods that can be tried. This chapter attempts to introduce the main ideas which will be fleshed out in the spreadsheet models of the subsequent four chapters. Since the concepts are interlinked and used in several ...