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Two-state option pricing model

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Definition of Two-state option pricing model

Two-state Option Pricing Model Image 1

Two-state option pricing model

An option pricing model in which the underlying asset can take on only two
possible (discrete) values in the next time period for each value it can take on in the preceding time period.
Also called the binomial option pricing model.



Related Terms:

Abandonment option

The option of terminating an investment earlier than originally planned.


Act of state doctrine

This doctrine says that a nation is sovereign within its own borders and its domestic
actions may not be questioned in the courts of another nation.


Administrative pricing rules

IRS rules used to allocate income on export sales to a foreign sales corporation.


American option

An option that may be exercised at any time up to and including the expiration date.
Related: European option


American option

An option that can be exercised any time until its
expiration date. Contrast with European option.



American-style option

An option contract that can be exercised at any time between the date of purchase and
the expiration date. Most exchange-traded options are American style.


Arbitrage-free option-pricing models

Yield curve option-pricing models.


Two-state Option Pricing Model Image 2

Arbitrage Pricing Theory (APT)

An alternative model to the capital asset pricing model developed by
Stephen Ross and based purely on arbitrage arguments.


Asian option

option based on the average price of the asset during the life of the option.


Asset pricing model

A model for determining the required rate of return on an asset.


Asset pricing model

A model, such as the Capital Asset pricing model (CAPM), that determines the required
rate of return on a particular asset.


Bargain-purchase-price option

Gives the lessee the option to purchase the asset at a price below fair market
value when the lease expires.


Barrier options

Contracts with trigger points that, when crossed, automatically generate buying or selling of
other options. These are very exotic options.


Basket options

Packages that involve the exchange of more than two currencies against a base currency at
expiration. The basket option buyer purchases the right, but not the obligation, to receive designated
currencies in exchange for a base currency, either at the prevailing spot market rate or at a prearranged rate of
exchange. A basket option is generally used by multinational corporations with multicurrency cash flows
since it is generally cheaper to buy an option on a basket of currencies than to buy individual options on each
of the currencies that make up the basket.


Binomial model

A method of pricing options or other equity derivatives in
which the probability over time of each possible price follows a binomial
distribution. The basic assumption is that prices can move to only two values
(one higher and one lower) over any short time period.


Binomial option pricing model

An option pricing model in which the underlying asset can take on only two
possible, discrete values in the next time period for each value that it can take on in the preceding time period.


Black-Scholes model

The first complete mathematical model for pricing
options, developed by Fischer Black and Myron Scholes. It examines market
price, strike price, volatility, time to expiration, and interest rates. It is limited
to only certain kinds of options.


Black-Scholes option-pricing model

A model for pricing call options based on arbitrage arguments that uses
the stock price, the exercise price, the risk-free interest rate, the time to expiration, and the standard deviation
of the stock return.



cafeteria plan a “menu” of fringe benefit options that include

cash or nontaxable benefits


Call an option

To exercise a call option.


Call option

An option contract that gives its holder the right (but not the obligation) to purchase a specified
number of shares of the underlying stock at the given strike price, on or before the expiration date of the
contract.
Call premium
Premium in price above the par value of a bond or share of preferred stock that must be paid to
holders to redeem the bond or share of preferred stock before its scheduled maturity date.


Call Option

A contract that gives the holder the right to buy an asset for a
specified price on or before a given expiration (maturity) date


call option

Right to buy an asset at a specified exercise price on or before the exercise date.


Capital asset pricing model (CAPM)

An economic theory that describes the relationship between risk and
expected return, and serves as a model for the pricing of risky securities. The CAPM asserts that the only risk
that is priced by rational investors is systematic risk, because that risk cannot be eliminated by diversification.
The CAPM says that the expected return of a security or a portfolio is equal to the rate on a risk-free security
plus a risk premium.


Capital Asset Pricing Model (CAPM)

A model for estimating equilibrium rates of return and values of
assets in financial markets; uses beta as a measure of asset risk
relative to market risk


capital asset pricing model (CAPM)

Theory of the relationship between risk and return which states that the expected risk
premium on any security equals its beta times the market risk premium.


CASH-FLOW STATEMENT

A statement that shows where a company’s cash came from and where it went for a period of time, such as a year.


Cash Flow statement

A financial report that shows the movement in cash for a business during an accounting period.



common-size income statement

Income statement that presents items as a percentage of revenues.


Compound option

option on an option.


constant-growth dividend discount model

Version of the dividend discount model in which dividends grow at a constant rate.


Constant-growth model

Also called the Gordon-Shapiro model, an application of the dividend discount
model which assumes (1) a fixed growth rate for future dividends and (2) a single discount rate.


Convention statement

An annual statement filed by a life insurance company in each state where it does
business in compliance with that state's regulations. The statement and supporting documents show, among
other things, the assets, liabilities, and surplus of the reporting company.


Cost-plus pricing

A method of pricing in which a mark-up is added to the total product/service cost.


Covered or hedge option strategies

Strategies that involve a position in an option as well as a position in the
underlying stock, designed so that one position will help offset any unfavorable price movement in the other,
including covered call writing and protective put buying. Related: naked strategies


Currency option

An option to buy or sell a foreign currency.


Dealer options

Over-the-counter options, such as those offered by government and mortgage-backed
securities dealers.


Delivery options

The options available to the seller of an interest rate futures contract, including the quality
option, the timing option, and the wild card option. Delivery options make the buyer uncertain of which
Treasury Bond will be delivered or when it will be delivered.


Deterministic models

Liability-matching models that assume that the liability payments and the asset cash
flows are known with certainty. Related: Compare stochastic models


Discounted dividend model (DDM)

A formula to estimate the intrinsic value of a firm by figuring the
present value of all expected future dividends.


dividend discount model

Computation of today’s stock price which states that share value equals the present value of all expected future dividends.


Dividend discount model (DDM)

A model for valuing the common stock of a company, based on the
present value of the expected cash flows.


Dividend growth model

A model wherein dividends are assumed to be at a constant rate in perpetuity.


Doubling option

A sinking fund provision that may allow repurchase of twice the required number of bonds
at the sinking fund call price.


Down-and-in option

Barrier option that comes into existence if asset price hits a barrier.


Down-and-out option

Barrier option that expires if asset price hits a barrier.


dual pricing arrangement

a transfer pricing system that allows
a selling division to record the transfer of goods or
services at one price (e.g., a market or negotiated market
price) and a buying division to record the transfer at another
price (e.g., a cost-based amount)


economic components model

Abrams’ model for calculating DLOM based on the interaction of discounts from four economic components.
This model consists of four components: the measure of the economic impact of the delay-to-sale, monopsony power to buyers, and incremental transactions costs to both buyers and sellers.


Elasticity of an option

Percentage change in the value of an option given a 1% change in the value of the
option's underlying stock.


Embedded option

An option that is part of the structure of a bond that provides either the bondholder or
issuer the right to take some action against the other party, as opposed to a bare option, which trades
separately from any underlying security.


Equity options

Securities that give the holder the right to buy or sell a specified number of shares of stock, at
a specified price for a certain (limited) time period. Typically one option equals 100 shares of stock.


Escalating Price Option

A nonqualified stock option that uses a sliding scale for
the option price that changes in concert with a peer group index.


Estate Planning

An insurance program designed to provide funds for insured's dependents upon death of the insured, and to also conserve, as much as possible, the personal assets that the insured wants to bequeath to heirs.


European option

option that may be exercised only at the expiration date. Related: american option.


European option

An option that can be exercised only on its expiration date.
Contrast with American option.


European-style option

An option contract that can only be exercised on the expiration date.


Exercising the option

The act buying or selling the underlying asset via the option contract.


Exit Options

A variety of options available to an investor to recover their invested capital and the return on their investment.


External Financial Statements

Corporate financial statements that have been reported on by an external independent accountant.


Extrapolative statistical models

models that apply a formula to historical data and project results for a
future period. Such models include the simple linear trend model, the simple exponential model, and the
simple autoregressive model.


Factor model

A way of decomposing the factors that influence a security's rate of return into common and
firm-specific influences.


financial reports and statements

Financial means having to do with
money and economic wealth. statement means a formal presentation.
Financial reports are printed and a copy is sent to each owner and each
major lender of the business. Most public corporations make their financial
reports available on a web site, so all or part of the financial report
can be downloaded by anyone. Businesses prepare three primary financial
statements: the statement of financial condition, or balance sheet;
the statement of cash flows; and the income statement. These three key
financial statements constitute the core of the periodic financial reports
that are distributed outside a business to its shareowners and lenders.
Financial reports also include footnotes to the financial statements and
much other information. Financial statements are prepared according to
generally accepted accounting principles (GAAP), which are the authoritative
rules that govern the measurement of net income and the reporting
of profit-making activities, financial condition, and cash flows.
Internal financial statements, although based on the same profit
accounting methods, report more information to managers for decision
making and control. Sometimes, financial statements are called simply
financials.


Financial reports or statements

The Profit and Loss account, Balance Sheet and Cash Flow statement of a business.


Foreign currency option

An option that conveys the right to buy or sell a specified amount of foreign
currency at a specified price within a specified time period.


Futures option

An option on a futures contract. Related: options on physicals.


Garmen-Kohlhagen option pricing model

A widely used model for pricing foreign currency options.


Gordon model

present value of a perpetuity with growth.
The end-ofyear Gordon model formula is: 1/(r - g)
and the midyear formula is: SQRT(1 + r)/(r - g).


Greenshoe option

option that allows the underwriter for a new issue to buy and resell additional shares.


Heavenly Parachute Stock Option

A nonqualified stock option that allows a deceased option holder’s estate up to three years in which to exercise his or her
options.


Incentive Stock Option

An option to purchase company stock that is not taxable
to the employee at the time it is granted nor at the time when the employee
eventually exercises the option to buy stock.


INCOME STATEMENT

An accounting statement that summarizes information about a company in the following format:
Net Sales
– Cost of goods sold
--------------------
Gross profit
– Operating expenses
--------------------
Earnings before income tax
– Income tax
--------------------
= Net income or (Net loss)
Formally called a “consolidated earnings statement,” it covers a period of time such as a quarter or a year.


Income Statement

One of the basic financial statements; it lists the revenue and expense accounts of the company.
The Income statement is prepared for a given period of time.


income statement

Financial statement that summarizes sales revenue
and expenses for a period and reports one or more profit lines for the
period. It’s one of the three primary financial statements of a business.
The bottom-line profit figure is labeled net income or net earnings by
most businesses. Externally reported income statements disclose less
information than do internal management profit reports—but both are
based on the same profit accounting principles and methods. Keep in
mind that profit is not known until accountants complete the recording
of sales revenue and expenses for the period (as well as determining any
extraordinary gains and losses that should be recorded in the period).
Profit measurement depends on the reliability of a business’s accounting
system and the choices of accounting methods by the business. Caution:
A business may engage in certain manipulations of its accounting methods,
and managers may intervene in the normal course of operations for
the purpose of improving the amount of profit recorded in the period,
which is called earnings management, income smoothing, cooking the
books, and other pejorative terms.


Income statement

A financial report that summarizes a company’s revenue, cost of
goods sold, gross margin, other costs, income, and tax obligations.


income statement

Financial statement that shows the revenues, expenses, and net income of a firm over a period of time.


Income statement (statement of operations)

A statement showing the revenues, expenses, and income (the
difference between revenues and expenses) of a corporation over some period of time.


Income Statements

A financial statement that displays a breakdown of total sales and total expenses.


Index and Option Market (IOM)

A division of the CME established in 1982 for trading stock index
products and options. Related: Chicago Mercantile Exchange (CME).


Index model

A model of stock returns using a market index such as the S&P 500 to represent common or
systematic risk factors.


Index option

A call or put option based on a stock market index.


Interest Option

One of several investment accounts in which your premiums may be invested within your life insurance policy.


Internet business model

a model that involves
(1) few physical assets,
(2) little management hierarchy, and
(3) a direct pipeline to customers


Intestate

This means dying without a will, in which case the provincial laws of the province in which the death occurred apply to the manner in which assets will be distributed. In other words, if you don't write your own will, the government will do it for you after your death and it may not be as you would have wished.


Intrinsic value of an option

The amount by which an option is in-the-money. An option which is not in-themoney
has no intrinsic value. Related: in-the-money.


Irrational call option

The implied call imbedded in the MBS. Identified as irrational because the call is
sometimes not exercised when it is in the money (interest rates are below the threshold to refinance).
Sometimes exercised when not in the money (home sold without regard to the relative level of interest rates).


Liquid yield option note (LYON)

Zero-coupon, callable, putable, convertible bond invented by Merrill


Liquid yield option note (LYON)

Zero-coupon, callable, putable, convertible bond invented by Merrill Lynch & Co.


log size model

Abrams’ model to calculate discount rates as a function of the logarithm of the value of the firm.


Lookback option

An option that allows the buyer to choose as the option strike price any price of the
underlying asset that has occurred during the life of the option. If a call, the buyer will choose the minimal
price, whereas if a put, the buyer will choose the maximum price. This option will always be in the money.


Margin requirement (Options)

The amount of cash an uncovered (naked) option writer is required to
deposit and maintain to cover his daily position valuation and reasonably foreseeable intra-day price changes.


Market model

This relationship is sometimes called the single-index model. The market model says that the
return on a security depends on the return on the market portfolio and the extent of the security's
responsiveness as measured, by beta. In addition, the return will also depend on conditions that are unique to
the firm. Graphically, the market model can be depicted as a line fitted to a plot of asset returns against
returns on the market portfolio.


Markowitz model

A model for selecting an optimum investment portfolio,
devised by H. M. Markowitz. It uses a discrete-time, continuous-outcome
approach for modeling investment problems, often called the mean-variance
paradigm. See Efficient frontier.


mission statement

a written expression of organizational purpose that describes how the organization uniquely meets its targeted customers’ needs with its products or services


Modeling

The process of creating a depiction of reality, such as a graph, picture, or mathematical
representation.


Multi-option financing facility

A syndicated confirmed credit line with attached options.


Naked option strategies

An unhedged strategy making exclusive use of one of the following: Long call
strategy (buying call options ), short call strategy (selling or writing call options), Long put strategy (buying
put options ), and short put strategy (selling or writing put options). By themselves, these positions are called
naked strategies because they do not involve an offsetting or risk-reducing position in another option or the
underlying security.
Related: covered option strategies.


network organization

a flexible organization structure that
establishes a working relationship among multiple entities,
usually to pursue a single function


Nonqualified Stock Option

A stock option not given any favorable tax treatment
under the Internal Revenue Code. The option is taxed when it is exercised,
based on the difference between the option price and the fair market
value of the stock on that day.


Notes to the financial statements

A detailed set of notes immediately following the financial statements in
an annual report that explain and expand on the information in the financial statements.



 

 

 

 

 

 

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