28 Nov

Option Valuation by Various Methods | CA Final SFM

Options Valuation

Option valuation refers to the amount of premium to be determined. In other words, what should be the fair amount of an option premium? Determining such fair value or fair premium is known as option valuation.

Once option valuation is made, one will come to know as to what should be the premium for a particulars option. On comparing such fair premium with the actual premium, the investor can decide whether he should buy such options or sell such options.

Consider the following situations:

  1. If actual premium is more than the fair premium, the option premium is considered to be overpriced and the investor will prefer selling or writing such option.
  2. If actual premium is less than the fair premium, the option premium is considered to be underpriced and the investor will prefer buying or holding such option.

For determining fair value of an option, there are various approaches or models. These are mentioned below:

  1. Portfolio Replication Model
  2. Risk Neutral Model
  3. Binomial Model
  4. Black & Scholes Model

All the above approaches can be used for determining the value of call options only. For determining the value of put options, the following procedure should be used:

  1. Determine the value of call option for the same exercise price.
  2. Use ‘Put-Call Parity’ Theory for determining the value of put option through the value of call option.

Portfolio Replication Model

This model creates a portfolio of stock and then creates a replica of such stock portfolio through options (Call Options). In other words, the created option portfolio should appear as a replication of the stock portfolio. The stock portfolio will contain a single equity share whose option valuation is required. The option portfolio on the other hand will contain one or more than one option to match with the stock portfolio. Through this created match, the value of a call option can be determined.

Risk Neutral Model

As per Risk Neutral Model the risk free rate of interest is a weighted average of rate of returns at higher and lower probable prices where the weights used represents the probabilities of rise and fall in prices.

Binomial Model

C = Value of Call Option at present

Cu = value of call option on expiry when price goes up

Cd = Value of call option on expiry when price goes down

I = 1 + i ( 1 + Risk free Interest rate)

U = 1 + ROR when Price goes up

D = 1 + ROR when price goes down

Latest Posts

Tips by CA Harish Wadhwani (Scored 93 marks in SFM)

Congratulations…!! CA Harish Wadhwani for scoring 93 marks in SFM (CA Final)

Securitization CA Final SFM (Strategic Financial Management)

Securitization CA Final SFM Securitisation a chapter in Strategic Financial Management (SFM). This is an important chapter from the CA Exam point of view as well. The concept has been explained with a comprehensive example, to make sure the concepts are very clear. It mainly talks about Debt Securitisation, Mortgage-Backed Securities, Securitisation Process, Credit Rating Continue reading

Things you should do before your CA Final Exams

Things you should do before your CA Final Exams Clearing CA Final Exam is clearly not a simple cake walk. You need to be extremely committed to attending your CA final coaching classes. As the subjects are numerous, you need to study your lessons as and when they’re taught your respective CA final Coaching class. Continue reading

CA Final SFM, quick preparation tips

CA final SFM has a few topics which carry a fine weight-age in each trial which are Foreign Exchange Risk Management, Capital Budgeting, Derivatives, and Portfolio Management. But in its place of starting with a topic keeping huge concepts start with a bit lighter note and extremely interesting niche i.e. Bold Valuation. Thereafter full acquisition Continue reading

Two Way Quotes | Forex | CA Final SFM

 A Two way Quote indicates a set of two different rates of exchange known as Bid Rate and Ask Rate. In a Two Way Quotes, the rate at which bank will buy the currency and the customer will sell the currency is known as Bid Rate. The rate at which bank will sell the Continue reading

What is an Exchange Rate | Direct Quote & Indirect Quote

 Exchange Rate A rate at which one currency can be exchanged with the other. It is a rate at which one currency expressed in terms of the other. It is a rate at which a currency can be bought or sold. Direct Quote & Indirect Quote

Corporate Valuation Basics | CA Final SFM

 Need for Corporate Valuation Along with the enterprise growth, number of stakeholders also grows. Presentation of annual financial statements becomes. Curiosity of the stakeholders to understand the ‘true worth’ of their enterprise becomes translated to the concept of ‘valuation’. The market analysts, financial intermediaries, and the academicians, also attempt to apply their valuation approaches Continue reading

Interest Rate Futures | Derivatives | CA Final SFM

 When Forward Interest Rate Agreements are regulated through the “Exchange”, it will become Interest Rate Futures. However, the mechanism of IRF is different from FRA. The system is designed in a manner that interest rate is made up as a marketable product. The following example, will clarify as to how interest rate futures are Continue reading