5.b Binomial Option Pricing Model

Theories of Options Pricing Models

1. Binomial Option Pricing Model

The binomial model provides a discrete-time framework for option valuation. It models the underlying asset's price movements over time as a binomial tree, where each node represents a possible price at a given point.

Key Features: - Models price changes in discrete time intervals. - Considers the possibility of early exercise (important for American options). - Flexible in handling various types of options and underlying assets.

Example: Consider a stock currently priced at $100. In one period, it can either move up to $110 or down to $90. The binomial model calculates the option's value by working backward from the expiration, determining the payoff at each final node, and discounting it to the present value.