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.
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.