What is Option Pricing Theory

The financial markets use stochastic models to represent the seemingly random behavior of assets such as stocks, commodities, relative currency prices such as the price of one currency compared to that of another, such as the price of US Dollar compared to that of the Euro, and interest rates. These models are then used by quantitative analysts to value options on stock prices, bond prices, and on interest rates. This chapter gives an overview of the stochastic models and methods used in financial risk management. Given the random nature of future events on financial markets, the field of stochastic processes obviously plays an important role in quantitative risk management. Random walk, Brownian motion and geometric Brownian motion processes in risk management are explained. Simulations of these processes are provided with some software codes.