Option Pricing and Valuation of Contingent Cash Flow

This chapter introduces the concept of option, the principle and method for option valuation or option pricing. Generally, discounting and option pricing are the two complementary rather than competing valuation tools. Discounting is suitable to value future cash flows which are volatile but certain in existence; while option pricing is suitable to value future cash flows which are contingent and uncertain in existence. Further, option as a financial instrument can divided risk from return or isolate risk absolutely. This implies that option pricing is the most powerful tool to consider or evaluate risk. In 1997, the Nobel Prize in economics was awarded to the contributors in option pricing achievements, Scholes and Merton, and affirmed the huge application potential of option pricing. Unfortunately, financial research has not fully tapped this potential after that, which is part of the reason for many fundamental and related financial problems remained unsolved so far. Of course, this chapter introduces the option pricing theory and method, especially the Black–Scholes model, classifies real options in investment, financing and operation, and further reclassifies the valuation methods. All those pave the way for the subsequent chapters to apply the option pricing method to solve the relevant financial problems.