Chp.

8 Theory of Rational
Option Pricing
Kangchaofeng
Kcfxm@163.com

 8.1 Why? Option is a particularly simple

type of contingent-claim asset, so a theory
of option pricing may leading to general
theory of contingent-claims pricing.

8.2 Restrictions on Rational

Option Pricing

 Dominant :

Security(portfolio) A is dominant over security

(portfolio) B if, on some known date in the future,
the return on A will exceed the return on B for
some possible states of the world.
Assumption 1: A necessary condition for
rational option pricing theory is that the option be
priced such that it is neither a dominant nor a
dominated security.

 Theorem 8.2

If the hypothesized conditions for Theorem

8.1 hold, an American warrant will never
be exercised prior to expiration, and hence
it has the same value as a European
warrant.

 Theorem 8.3

If the hypothesized conditions for Theorem

8.1 hold, the value of a perpetual warrant
must equal the value of the common
stock.

F 1, ; E3 F 1, ; E1 1 F 1, ; E2

 8.3 Effects of Dividends and Changing

Exercise Price

contents:

 Definition: An
option is said to be payout protected if, for
a fixed investment policy and fixed capital
structure, the value of the option is
invariant to the choice of payout policy.

max 0, s E max 0, s E /
x

 B-S

F1 S , 1 ; E1 max 0, S E1 , F0 S , 1 ; E0

 Corollary 8.11b If there is a finite number

of changes in the exercise price of payoutprotected perpetual warrant, then it will not
be exercised and its price will equal the
common stock price.

8.4 Restrictions on Rational Put

Option Pricing

8.5 Rational option Pricing along

Black-Scholes Lines

8.6 An Alternative Derivation of

the Black-Scholes Model

8.7 Extension of the Model to

include Dividend Payments and
Exercise Price Changes

8.8 Valuing an American Put

Option

8.9 Valuing the Down-and-out

Call Option

8.10 Valuing a Callable Warrant