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Financial Options Pricing History. Today we will learn How do Investors Price Options?

Welcome back so today’s video is the first in a series on pricing pricing options and so firstly we’re going to talk a little bit about the history of pricing options so options have actually been around for a very long time there are option like contracts that have existed since since ancient greece they wouldn’t have been options as we recognize them today

Like sort of put the car auctions but they would have been agreements to pay a certain amount of money upfront for the right to reserve will say all of presses and things like that that’s sort of the very first example of an option that that people can find and so they’ve been around for a long time but actually pricing formulas did not exist until the 1970s

The very first options pricing formula was published in 1973 and that’s the black scholes merton model a few years after that i guess about six years later in 1979 the binomial tree model was released by cox rasa and rubinstein before the existence of these models so people did trade options and they they were able to come up with prices for those options and

The prices were actually kind of fair you know they were without a model people were still able to work out what a reasonable amount to charge for for these these contracts was and actually what we find is that once the models came out the prices didn’t actually change massively so there was a there was a certain sense to what people were charging now the big

Difference is that the options market was actually very small before these pricing formulas came about so instead of you know the thousands of people who trade derivatives on a daily basis that we have today there would have been a small niche group of people who had a lot of market experience and who sort of understood the risks and understood how much you know

Given underlying was likely to move in a given period of time and could appropriately priced at auction and obviously if you were in the business of doing this and you were coming up with the wrong prices you you would bankrupt yourself over time and so the pricing formulas showed us quite a few things you know when when we talk about the black scholes model ie

In my classes i point out that it’s probably the greatest breakthrough in finance in the last hundred years and probably did the the great breakthrough before that was was the idea of present value in cash flows you know since it’s a big big deal but what’s special about it is not so much just that it told us you know mathematically the price of an option what’s

Special about it is it showed us how options behave as well and thus we were able to hedge options positions by trading in the underlying and we were actually able to create other we were able to create auction like payouts without actually having options exist just by a trading strategy which is actually specified by the black scholes model and we’ll learn about

That in a later video that i’ll do on dynamic hedging so generally options pricing models depend on the following factors so the spot price in the strike price will obviously matter a lot in pricing and auction the cost of holding a position in the underlying including things like the interest rate and – and dividends will matter the length of time to expiration

Will matter and that should be obvious to you that a an option that expires in a longer period of time is more valuable than enough that expires in a short amount of time the volatility of the underlying security and that’s kind of a big deal and that’s really one of the innovations that these early models brought to the table was that if we could you know if we

Could model the behavior of the underlying a sort of a random process with a given standard deviation that we could then price price options and and those are sort of the important factors that we use in pretty much all of our models for pricing options now before these models did exist we did know that options prices were made up of this combination of intrinsic

Value and untimed value and i’ve done a prior video on that if you want to take a look at that but yeah but before before we had these models we knew that an option was worth more than its intrinsic volume by that i mean that that will say if the underlying is trading to a hundred and there’s an option with a call option with a strike price 95 we would say that

That is five dollars in the money and has intrinsic value of five dollars but a rational investor would be happy to pay more than that for that option simply because it has this unlimited upside and capped downside and daddys manifested as x value in the option so options contracts can be taught of and were thought of as a lot like insurance contracts before

Before these models came about and as early as 1350 in palermo shipping insurance did exist shipping insurance was kind of amongst the first types of insurer and a popular contract at the time popular insurance contract was a conditional sale where the insurer agreed to buy the ship and cargo should it fail to arrive at its destination and so in order to price

That kind of derivative what you have to do is you have to look at the present value of the probability of the pair times the size of the payout okay so if you think there’s a 10% chance of the ship sinking you multiply 0.1 times the amount of money you’d have to pay out and then you discount it to its present value in order to take into account the time value

Of money and so before before options pricing models existed essentially people tried to price options using that sort of approach where they’d say well what is the probability of the of this underlying moving up or down through the strike price and and what it’s the lightly payout and and they they actually came up with reasonable values based upon that and

It was really more of an iterative approach than anything else so a big breakthrough in in the pricing of options who is low especially a a french mathematician in 1900 modeled the stochastic process that we call brownian motion he built a mathematical model of it in his phd thesis which was called the theory of speculation and it was actually the first paper

Using advanced mathematics in finance now the paper actually didn’t go that far didn’t get that much interest at the time and that was largely because the kind of people who were interested in mathematics weren’t interested in finance and the kind of people who were interested in finance weren’t interested in mathematics but that model was then taken up many

Years later in nineteen in the early 1970s by by the creators of the black scholes merton formula in order to build the point the the black scholes model and of course a lot of our other models in finance are based upon that so that kind of a quick history of of options pricing and in our next video we’re going to look the binomial tree approach we’ll look at

The first portfolio approach to pricing derivatives using a binomial tree so see you then bye

Transcribed from video

Financial Options Pricing History. How do Investors Price Options? By Patrick Boyle