Option Pricing Theory

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Definition of 'Option Pricing Theory'

Option pricing theory is a body of knowledge that deals with the valuation of options. Options are financial instruments that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specified date.

The Black-Scholes model is the most well-known option pricing model. It was developed by Fischer Black and Myron Scholes in 1973. The Black-Scholes model is a partial differential equation that can be used to price European options. European options can only be exercised on the expiration date.

The Black-Scholes model is based on a number of assumptions, including that the underlying asset follows a geometric Brownian motion, that the risk-free rate is constant, and that the option is the only traded derivative on the underlying asset.

The Black-Scholes model has been shown to be a very accurate pricing model for European options. However, it is not as accurate for American options, which can be exercised at any time before the expiration date.

There are a number of other option pricing models that have been developed over the years. These models include the binomial model, the Monte Carlo model, and the lattice model.

Option pricing theory is a complex and ever-evolving field. New models are constantly being developed, and new research is being conducted. As a result, the accuracy of option pricing models is constantly improving.

Option pricing theory is an important tool for investors and traders. It can be used to value options and to make informed investment decisions.

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