Pricing European options using simulations
Options are a type of derivative instrument because their price is linked to the price of the underlying security, such as stock. Buying an options contract grants the right, but not the obligation, to buy or sell an underlying asset at a set price (known as a strike) on/before a certain date. The main reason for the popularity of options is because they hedge away exposure to an asset's price moving in an undesirable way.
In this recipe we will focus on one type of options, that is, European options. A European call/put option gives us the right (but again, no obligation) to buy/sell a certain asset on a certain expiry date (commonly denoted as T).
There are many possible ways of option valuation, for example, using:
- Analytical formulas (only some kinds of options have those),
- Binomial tree approach,
- Finite differences,
- Monte Carlo simulations.
European options are an exception in the sense that there exists an analytical formula for...
