Ff options can only be priced because they can be replicated, why do we need them - Assignment Example

Although derivatives are technically conspicuous reason being they can undergo replication using basic financial instruments, they are still the tools that provide those who participate in the market to full of risk to manage the particular risks. Nature of options dynamic replication Dynamic hedging of options is never conducted even with the market makers(Lussier & PareI, 2004). In nature, options are hard to deal with due to the technicality of the language used to describe the tools. The difference between dynamic and static hedging is small since hedging is only realized on minor positions.

The risks taken by either parties are very different and highly distinguished, those with the buyer and distinct from those with the writer of the options hence asymmetry in the payoffs making it very hard for dynamic replication. Options also have the tendency of changing their character in a dynamically replicative way depending on whether they are in the money or out of the money. Dependent on this, is the fact that the value of out of the money option is the probability that at expiry the said option will have some value without dynamically replicating (Lussier & PareI, 2004).

Dynamic replication assumes a constant movement of asset prices while the real prices of the assets can move non-constantly. This has the effect of derailing the possible outcomes of accurate replication. The risk presented by this is on the options themselves upbringing bankruptcy to businesses that do not have enough capital (Lussier & PareI, 2004). All these factors combined have an impact on the way both the put and the call options will be priced using the relevant dynamic models. Options are of very high value since in its own context it allows the person holding it to be able to modify the risks they are exposed to favorably.

In addition, the asset also gives the holder the special chance of escaping the contract when they realize they are not favored by the occurrences of dynamic replication. Pricing of options in relation to dynamic replication Dynamic replication understanding can well be discussed and how it works in relation to the option pricing theory, their relation and functionality is as well discussed. The pricing of options today bases its pricing on discrete time method where the valuation of the asset will take only two general forms depending on the skewness of dynamic replication (Roman, 2004).

The pricing of an option depends on the ability of an individual to predict the future behavior of the asset prices. The call option value is arrived at in the end by getting the difference between the asset price and the strike price of the asset, which is maximized incase it is positive in value, and minimized when the value is negative. Under option contracts, option writers are most of the times obligated to deliver some form of liability with regard to dynamic replication, which are valued by way of creating a diversified portfolio that is underlying and that exactly matches the residual costs involved in setting up both sides leading to a replicated product (Roman, 2004).

Arrival at the fair value of an option is therefore arrived at depending on the ability of the writer of the option to form a dynamically replicating portfolio of the assets. Among the many methods used to price options, we have the Black-Scholes option-valuation model (Ross, 2008), which employs intensive analysis in its