Define the concept of option pricing

An option is a security that grants the right to buy or sell the given underlying asset within the specified conditions. Options are really important for many reasons in financial economics. Options are generally stocks, bonds, financial assets and commodities that are traded in markets. During 1970‟s, there was significant research on pricing the options. As option is a security whose pay off is based on the underlying assets, many corporate liabilities are expressed as options. The amount for a share that an option buyer pays to the seller is known as option price. The significance of option pricing in insurance is mainly due to the domain of life insurance. Option pricing theory is used mainly for life insurance agreements. The early insurance application of Black Scholes model was related to the pricing of loan guarantees and deposit insurance.

Types of options
The two types of options are call option and put option. Call option offers the rights to buy a specified asset like stocks at a particular price during specified period. Put option provides the rights to sell the specified underlying asset at an exercised date during specific period i.e. before the expiry date. Generally there will be two parties for an option contract i.e. the buyer of the option who buys the particular asset and seller of the option who sells the underlying asset. The seller of the option commences option contract. Hence seller of the option is known as „writer‟. The act of selling the option is known as writing an option.
For instance, a pharmacy company's share (current market price) is Rs 200. An option contract is generated based on this and traded. A call option will give the rights to buy this share at Rs 210 for next three months. This created call option will be distributed between Purchaser and Seller. The Purchaser will pay a small amount known as "option premium" of say Rs 10 to the Seller.
When the owner of call option procures the underlying asset, then the owner exercises the option. The seller of the option is then allowed to sell the underlying asset at a specified rate to the owner according to the option contract. Now the buyer of the option should exercise the option on or  before the expiry date. Otherwise the option is said to be unexercised. In put option, the buyer of the option has the rights to sell the underlying asset. If the buyer exercises the right to sell the underlying asset, then the seller of the option should buy it from the buyer at a specified rate or exercised price.
 

Other types of options are: 

Stock options - A stock option is an agreement between two parties in which the stock holder (buyer of the option) has the right to buy/sell shares of an underlying stock at a specified price from/to the stock writer (seller of the option) within the fixed period of time. 

Currency options - A currency option is a contract whereby the buyer of the option has the rights to buy or sell an underlying asset. The exercise price determines the exchange rate between two currencies in terms of base currency per unit Indian currency. For instance, suppose exchange rate is Rs 50, then an option contract is created and traded based on this share. A call option gives the right to procure the share at a specified rate say Rs 51 for next three months. Then this call option will be traded for between two groups - purchaser and seller. The purchaser pays a small price for the share known as option premium to the seller. 

American/European options - An option contract is valid for a limited period of time. The validity period of an option contract is known as maturity or expiry date. Depending upon the maturity pattern of options, option contracts are classified in to European options and American options. Options that are exercised only on maturity date of the option or the expiry date is known as European option. American option is exercised till and including the expiry date. 

Exchange traded vs. OTC options - Currency options are traded either on organised exchange rates or in OTC (over the counter) market. Options that are traded on organised exchanges are size, strike price, expiry date etc. The OTC traded option contract will have the shares as the underlying assets according to the needs of the consumers. The OTC options market is referred as an inter-bank market as the major private players in the market are the commercial and investment banks. The exchange traded options mainly trade on the exchange rates of the shares. In exchange traded options, the connection or link between buyer and seller of the option is finished soon after the contract is finalised. But in case of OTC traded options, the link between the buyer and seller sustains till the final settlement of the contract. The transaction rates of OTC traded options are higher according to the needs of the customers.