ABSTRACT
Chapter overview: This chapter marks the beginning of option pricing, which is the central theme of Part II of this book. Unlike the pricing of prepaid forwards and forwards, option pricing is inherently model-dependent, i.e., different models of the stock price give rise to different option prices. Consider, for instance, the pricing of a K-strike call. Loosely speaking, the price of the call depends on the thickness of the right tail of the stock price distribution beyond the strike price K. The more likely the stock stays above K at expiration, the higher the call price. Similar considerations apply to a put, for which the left tail of the stock price distribution plays a pivotal role.
