30 years: Risk management & derivatives trading

In this video, Lindsey explains how the simple valuation model is established and also talks us through how the model is used in practice

In this video, Lindsey explains how the simple valuation model is established and also talks us through how the model is used in practice

10 mins 53 secs

Overview

How would we value an out-of-the-money option? The value from an OTM option comes from the volatility. If the underlying was not volatile, the option could never be in the money and would have zero value. We therefore need a model that translates volatility of the underlying into option value. In order to value options we need a distribution of the value of the underlying at expiration, with probabilities attached to various possible outcomes, let's see how this works.

Key learning objectives:

Outline the simple option valuation model

Understand how the model is used in practice

Summary#### How is the simple option valuation model established?

To value options, we need a distribution of the value of the underlying at expiration, with probabilities attached to various possible outcomes. The model allows for 5 possible values, with a symmetrical distribution around a central value, as outlined below.

The middle value should be equal to the forward price for the expiration we are looking at.

The width of the bars depends on the volatility of the underlying. The width of the bars is calculated as Annual volatility x √Time. Therefore if the forward was 1,000 and the 3-month volatility was 5%, the bar width would be 50.

Once the central value and the width of the bars have been established you can calculate the payoff at expiry, as shown here:

And once that has been calculated, you can then calculate the value at expiry (image is for reference only and refers to valuing a call option with a $950 strike price).

Lindsey runs Perfordiant, an investment risk and performance consulting firm. He has worked in financial markets since 1992. Lindsey became an MD in fixed income and equities, ran a Risk function, and was on the management team of an Asset Management fintech business. Lindsey is now a Visiting Fellow at the Henley Business School, and resides on the board of CFA UK.

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