School of Management

MSc in Finance

Financial Option Pricing

MODULE INFORMATION
Academic Year: 2011/12 Year: Postgraduate Lectures: 9 Semester: 2

Lectures: Monday 14:00-16:00 AC LT and Friday 12:00-14:00 AC LT

MODULE LECTURERS
Lecturer: Sandra Nolte Office: KEB 515 Telephone: 0116 252 5634 Email: Sandra.Nolte@le.ac.uk Office Hours: TBA

MODULE AIMS AND OBJECTIVES

Aims
This course emphasizes option pricing and studies in particular the pricing models underlying option pricing. We study first the binomial pricing model in detail and learn about the concept of risk neutral pricing. We also consider the non-arbitrage theorem which is central in the theory of asset pricing. We move over then to the Black-Scholes model. We study the meaning of an Ito process and the well known Ito Lemma. We discuss some of the properties of a stochastic process, like quadratic variation. We study in detail the derivation of the Black-Scholes partial differential equation. We also consider a solution approach to this equation. The course continues with a study of the relationship between the BlackScholes model and the binomial pricing model. Finally, we attempt to extend the model. We consider some volatility functions (other than the constant volatility!). We also investigate in detail what happens to the pricing of options when the existence of arbitrage is allowed. Finally, time permitting; we consider alternative approaches to deriving the Black-Scholes

model. Please note this course is self contained. However, a lot of new concepts will need to be absorbed in a short period of time.

Objectives
At the end of this module you should have an understanding of: how to price options with the binomial tree the significance of the Ito Lemma and Ito process; the basic properties of stochastic processes; the derivation of the Black-Scholes partial differential; how to possibly solve this partial differential: the relationship between the Binomial pricing model and the Black-Scholes model; how the Black-Scholes model is affected when considering non-constant volatility functions how the Black-Scholes model is affected when allowing for the existence of arbitrage how the Black-Scholes model can be derived in alternative ways

TEACHING METHODS
The module will be taught through a series of two-hour lectures. Exercises will be covered during the lecture

ASSESSMENT
This module is assessed through coursework (100%). You are required to solve a set of exercises. Further advice on the question will be given in the classes. Submission deadline: Friday 11 May 2012

READING LIST
Hull J. C.; Options, Futures and Other Derivatives; Prentice Hall; Eight Edition; 2012 (all previous editions are fine too). Further readings will be provided in the lectures. Lecture notes wil be posted on Blackboard before or after the lecture.

MODULE CONTENTS
Topics to be covered are as follows (subject to amendments). Lectures below are expressed in slots of 2 hours each.

Lecture topics What is an option; European put-call parity (derivation); American put-call parity; Trading Strategies

Class

Lecture 1

Trading Strategies (contd); derivation of the binomial option pricing model; the concept of Risk Neutral Probability; Application of the binomial model

Lecture 2

Stochastic Processes; discrete time versus continuous time, introduction of simple Ito process

Lecture 3

Distribution of returns; derivation of Itos Lemma in the Black-Scholes option pricing model

Lecture 4

Derivation of the Black-Scholes option partial differential equation

Lecture 5

Properties of Black-Scholes; Implied volatility

Lecture 6

The Greek Letters

Lecture 7

Volatility Smiles

Lecture 8

Arbitrage based option pricing; outlook about more options

Lecture 9