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Mar 8

Compound option pricing

Posted by abiao at 21:09 | Code » Matlab | Comments(1) | Reads(11859)
A compound option is simply an option on an option. The exercise payoff of a compound option involves the value of another option. A compound option then has two expiration dates and two strike prices. Take the example of a European style call on a call. On the first expiration date T1, the holder has the right to buy a new call using the strike price X1. The new call has expiration date T2 and strike price X2.

The pricing of many other derivative instruments can be modeled as compound options. By visualizing the underlying stock as an option on the firm value, an option on stock of a levered firm that expires earlier than the maturity date of the debt issued by the
firm can be regarded as a compound option on the firm value (Geske, 1979). On the expiration of the option (the first expiration date of the compound option), the holder chooses to acquire the stock or otherwise. The decision depends on whether the stock as a call on the firm value is more valuable than the strike price.

Attached is a sample matlab code computing the value of a compound call option with the Black-Scholes pricing model using Geske's analytic formulas.

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You can find an Excel spreadsheets for pricing compound options at:
Compound Options in Excel
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