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Binomial Option Pricing Model Explained

The document describes the binomial option pricing model, which uses a binomial tree to model how the price of an underlying asset may change over time. It allows the asset price to move up or down according to predefined probability factors at each time period or node. The model is useful for pricing options and embedded options, though it is limited by only allowing for two possible asset prices at each node. An example is provided to demonstrate how to price a call option using the model.

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Preemnath Katare
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14 views8 pages

Binomial Option Pricing Model Explained

The document describes the binomial option pricing model, which uses a binomial tree to model how the price of an underlying asset may change over time. It allows the asset price to move up or down according to predefined probability factors at each time period or node. The model is useful for pricing options and embedded options, though it is limited by only allowing for two possible asset prices at each node. An example is provided to demonstrate how to price a call option using the model.

Uploaded by

Preemnath Katare
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd

Binomial Model

Derivative Securities By:


Preemnath Katare
MBA152041
Introduction

The binomial option pricing model is an options valuation method developed in 1979
The model uses an iterative procedure, allowing for the specification of nodes, or points in
time, during the time span between the valuation date and the option's expiration date.
The model reduces possibilities of price changes, and removes the possibility for arbitrage.
Binomial Tree

A graphical representation of possible intrinsic values that an option may take at different
nodes or time periods.
The value of the option depends
on the underlying stock or bond.
on the probability that the price of the underlying asset will either decrease or increase at any
given node.
Binomial trees are useful tools when pricing options and embedded options, but there is a
fundamental flaw with the model.
The underlying asset can only be worth exactly one of two possible values, which is not
realistic, as assets can be worth any number of values within any given range.
Example

Stock Price=100
Stock Price (Up state)=110
Stock Price ( Down state)=90
There is a call option available on this stock that expires in one month and has a strike
price of $100.
In the up state, this call option is worth $10, and in the down state, it is worth $0.
Lets assume that an investor purchases one-half share of stock and writes, or sells, one call
option.
Example

The total investment today is the price of half a share less the price of the option, and the
possible payoffs at the end of the month are:
Cost today = $50 - option price
Portfolio value (up state) = $55 - max ($110 - $100, 0) = $45
Portfolio value (down state) = $45 - max($90 - $100, 0) = $45
The portfolio payoff is equal no matter how the stock price moves.
Option price = $50 - $45 x e ^ (-risk-free rate x T)
e is the mathematical constant 2.7183
the risk-free rate is 3% per year, and T equals 0.0833 (one divided by 12), then the price of
the call option today is $5.11.
Two step Binomial Model

At each stage, the stock price moves up by a factor u or down by a factor d.


second step, there are two possible prices, u d S0 and d u S0. If these are equal, the lattice
is said to be recombining. If they are not equal, the lattice is said to be non-recombining.
u = 1/d
u d S0 = d u S0 = S0

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