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5.6. Decision trees and the option identification

Week 5 of the Course is devoted to options – one of the most interesting and advanced areas in finance. We start with definition, charts, payoffs – the basics of options. Then we move on to option valuation. We discuss replication and risk-neutral approaches and show on clear examples how they allow finding the option’s value under simplifying assumptions. We go further and discuss the generalizations of the simple approaches that lead to the Black–Scholes and binomial option valuation methods. Then we discuss the application of the option theory to valuing real investment projects that contain some options – the timing of investment, the abandonment, the follow up options. We show how decision trees and the option identification contribute to the better choice of investment projects. Finally, we briefly describe one of the most advanced topics in finance – the valuation of fixed-income instruments with embedded options and fixed-income derivatives including mortgage-backed securities and CMO’s.

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