# Pricing of a financial product : A pricer of a call option.

**ProbaPerception**, and kindly contributed to R-bloggers]. (You can report issue about the content on this page here)

Want to share your content on R-bloggers? click here if you have a blog, or here if you don't.

The financial market is not only made of stock options. Other financial products enable market actors to target specific aims. For example, an oil buyer like a flight company may want to cover the risk of increase in the price of oil. In this case it is possible to buy on the financial market what is known as a “Call” or a “Call Option”.

A Call Option is a contract between two counterparties (the flight company and a financial actor). The buyer of the Call has the opportunity but not the obligation to buy a certain quantity of a certain product (called the underlying) at a certain date (the maturity) for a certain price (the strike).

If the flight company doesn’t want to suffer from the risk of an increase of oil on the market within the next year, a Call Option of maturity 1 year, with a certain strike K may be bought. In this case, if the oil price on the market is over the strike, the flight company will use the Call option to buy oil for the price of the strike. If the price of the oil is lower than the strike, then the flight will not use the option and will buy oil on the market.

As you can see, this contract is not symmetric The flight company has an option (to buy or not to buy) while the second counterparty just follows the decision of the flight company. Therefore, the flight company will have to pay something to the second counterparty. One of the great question is how much should it be charged.

We will therefore use a pricing algorithm to estimate the price of this Call Option. We first build an algorithm to simulate the value of an asset in the model of Black-Scholes. Then we simulate the historical value of this asset in order to simulate the final value of the Call Option.

Indeed, if we know the value of the asset at the maturity (A(T)), we get directly the value of the Call Option of strike K at maturity : max(A(T) – K , 0).

Our asset is randomly distributed as:

A(t+dt) = A(t) (1 + r dt + v(B(t+dt) -B(t))

Where r is the interest rate, v the volatility of the asset and B a Brownian process (for more detail you can look at the post on Brownian motion).

After repeating the process many times, we estimate the mean of the Call Option for different strike in order to estimate the price of the Call Option.

As we can see the price of the Call decreases with the strike. Actually it converges towards 0. Indeed, the higher the strike is, the lower the chance are such that the asset goes over the strike.

What is done here can be done for many, many, many other financial products in order to price them by Monte Carlo.

__The code (R):__

sample.size <- 365

mu <- 0.1

sigma <- 0.2

a0 <- 1

Asset <- function(sample.size = 365, mu = 0.1, sigma = 0.2, a0 = 1){

dt <- 1/sample.size

sdt =sigma*sqrt(dt)

gauss <- rnorm(sample.size)

asset <- NULL

asset[1] <- a0 + mu + sigma * gauss[1]

test.default <- FALSE

for(i in 2:365){

if (!test.default){

asset[i] <- asset[i-1] * (1 + dt*mu + sdt * gauss[i])

}

else{

asset[i] <- 0

}

if (asset[i] <= 0){

asset[i] <- 0

test.default <- TRUE

}

}

return(asset)

}

PriceEstimation <- function(t, tf = 365, r = 0.1, strike = 1, n = 1000, mu = 0.1, sigma = 0.2, a0 = 1){

mean <- 0

for(i1 in 1:n){

mean <- mean + exp(-r*(tf-t)/tf) * max(0, (Asset(tf, mu, sigma, a0)-strike))

}

mean <- mean/n

return(mean)

}

res <- NULL

for(i in 1:length(seq(0, 3, 0.05))){

res[i] <- PriceEstimation(t = 0, tf = 365, r = 0.1, strike = seq(0, 3, 0.05)[i], n = 1000, mu = 0.1, sigma = 0.2, a0 = 1)

}

plot(seq(0,3, 0.05), res,type = ‘l’, xlab = “Strike Value”, ylab = “Price of the Call”)

**leave a comment**for the author, please follow the link and comment on their blog:

**ProbaPerception**.

R-bloggers.com offers

**daily e-mail updates**about R news and tutorials about learning R and many other topics. Click here if you're looking to post or find an R/data-science job.

Want to share your content on R-bloggers? click here if you have a blog, or here if you don't.