Empirical analysis and simulation of different option pricing models

Abstract

The Derivatives are financial instruments whose price is derived from the underlying assets and the value from the fluctuations of the underlying assets. These underlying assets are mostly equity stocks, bonds, currencies, interest rates, exchange rates, commodities and market indices. The derivatives can be classified into the following types Futures, Forwards, Options, Swaps and Credit Derivatives. The Derivative markets are markets where these derivative instruments are traded. The Derivative trading happens through i) Over-the-Counter (OTC) and ii) Exchange. Derivatives play a vital role in risk management of both financial and non-financial institutions. But, in the present world, it has become a rising concern that derivative market operations may destabilize the efficiency of financial markets. In today’s world the companies the financial and non-financial firms are using forward contracts, future contracts, options, swaps and other various combinations of derivatives to manage risk and to increase returns. It is true that growth of derivatives market reveal the increasing market demand for risk managing instruments in the economy. Worldwide, the total capitalization of the Derivatives market reached $370 trillion in 2007 which is around 30 times the size of the US economy($14.28 trillion) the largest economy in the world and nearly 7 times the GDP of the world ($54.62 trillion as of 20071 ). The open interest of the options and the futures market grew by 38% whilst the interest rate derivatives grew by 42%. The market cap of the options and futures market was $49 trillion. The stock market crash and ensuing global financial meltdown in 2008 has shown the importance of proper handling of the derivative instruments. The unravelling the Derivatives that has started with The Great Unwind of 2007 has put the global financial system in peril. The over exposure to the derivative markets has led to the downfall of many leviathans like Lehman Brothers, AIG, Fannie Mae and Freddie Mac among others.