**Option valuation models**

**Option valuation models**

Option valuation models use mathematical techniques to identify a range of possible future share prices at the exercise date. From these possible future share prices, the pay-off of an option can be calculated. These intrinsic values at exercise are then probability-weighted and discounted to their present value to estimate the fair value of the option at the grant date.

This narrative is part of the IFRS 2 series, look here.

**Model selection**

There are three main models used to value options:

- closed-form models: e.g. the BSM model;
- lattice models; and
- simulation models: e.g. Monte Carlo models.

These models generally result in very similar values if the same assumptions are used. However, certain models may be more restrictive than others – e.g. in terms of the different pay-offs that can be considered or assumptions that can be incorporated.

For example, a BSM model incorporates early exercise behaviour by using an expected term assumption that is shorter than the contractual life, whereas a lattice model or Monte Carlo model can incorporate more complex early exercise behaviour.

**Simple model explanation**

The approach followed in, for example, a lattice model illustrates the principles used in an option valuation model in a simplified manner.