Firstly let me apologize to the. NET developers perusing this blog, as this article is a little off-topic. However, my interests range over both. NET and derivatives, and I will be posting on both topics in the future. It is arguably the most important result in financial engineering, and is certainly a rich source of interview questions in the financial services industry. However, I think it is possible to get an intuitive understanding of what the various parts of the formula mean.
This article is an attempt to explain that. Note that to keep things simple here I am only going to discuss European call options on non-dividend paying stock. Firstly a reminder of what a European call option is. If I ask this in an interview I usually get the textbook answer: Whether I actually exercise my right clearly depends on the share price in the market at that date:.
Similarly if the share price is 40 I make a profit of I can buy more cheaply in the open market. This shows how the amount of money I make on my contract varies with the value of Microsoft stock at the end of the year. This premium is usually paid upfront at the start of the contract. The question is how much this premium is going to be?
Furthermore, the contract has different values depending on whether that stock price goes up or goes down: So intuitively we are going to need some measure, or measures, of the probabilities of the stock price ending up at various values after one year. If we have that it may be possible to apply an expected value calculation to get to a price for the contract. This is explained further in part 2.
View all posts by richnewman. Hats off and thanks a lot. Cool … Good Explanation. Can you also write about other option pricings as Black Scholes have many limitations and cant be used in real world. So, the chart should start at -5 where -5 is the price you paid to the other party to enter into the option contract.
The chart is intended to show the variation of money made or lost at maturity ignoring the premium payment. The text then goes on to say that because of this we have to pay a premium up front to enter the contract.
Could you you explain what Interest Rate Swap is? Hello, very lucid explanation. I had a query. If I were to use Black Scholes for patent valuation, what should be the strike and stock price in that case? The Black-Scholes Excel spreadsheet mentioned earlier in the comments has moved here: Please reply in layman terms.. I know its cumulative normal standard distribution, but what exactly it means? Kam — the normal distribution is one of the basic building blocks of statistics.
The easiest way to think of it is as the result of a series of experiments with random outcomes. For example, if you tossed a coin times you would get around 50 heads and 50 tails. If you repeated the experiment very many times you would have a distribution of outcomes: The actual distribution if you drew a graph of number of heads versus number of times they appeared would resemble the normal distribution: It turns out that this normal distribution is very useful for all kinds of statistical analysis, appears quite often in the real world, and has some mathematical properties that make it easy to work with.
The cumulative normal distribution is just a version of the same thing. In our example it is naively a graph got by replacing the actual number of heads on the y-axis of our graph by the sum of all the heads up to that point.
That is the value for 2 heads on the x-axis of the cumulative distribution is the sum of the values for 0, 1 and 2 heads on the regular distribution. The real cumulative normal is again continuous and scaled appropriately: Again this version of the normal distribution is useful in statistics.
Could you share some other concepts usually asked in interviews for finance-related jobs? You are commenting using your WordPress. You are commenting using your Twitter account. You are commenting using your Facebook account.
Notify me of new comments via email. Preface Firstly let me apologize to the. What is an Option? Whether I actually exercise my right clearly depends on the share price in the market at that date: Tagged beginners guide Black-Scholes derivatives made easy options pricing tutorial.
Published June 24, May 22, Bill The chart is intended to show the variation of money made or lost at maturity ignoring the premium payment. I read thousands of web pages, but this one was the simplest one. See wikipedia for the actual graphs: Leave a Reply Cancel reply Enter your comment here Fill in your details below or click an icon to log in: Email Address never made public.More...