What Is Binomial Option Pricing Model?

Comprehensive explanation of the Binomial Option Pricing Model, an iterative procedure for node specification in option valuation over a set period. Includes types, applications, examples, and comparisons.

The Binomial Option Pricing Model is a method in finance used to determine the fair value of an options contract. It was developed by Cox, Ross, and Rubinstein in 1979. This model uses an iterative procedure to specify the possible values of the option at different nodes within a specified time period.

Structure and Mathematical Foundation

Basic Principles

The fundamental principle behind the Binomial Option Pricing Model is to create a discrete-time model for the fluctuating price of the underlying asset. The model assumes that over each small time increment, the price of the asset can either move up or down by a certain factor, hence forming a binomial tree.

Given an asset price \( S \), the possible future prices can be outlined as:

$$ S_u = S \cdot u $$

$$ S_d = S \cdot d $$

where \( u \) is the factor by which the price moves up, and \( d \) is the factor by which the price moves down.

Calculation Formula

The model calculates the option’s value backwards from the expiration date to the current date using the risk-neutral valuation. The expected option payoff is discounted at the risk-free rate:

$$ C = \frac{1}{(1 + r)^\Delta t} \left[ p \cdot C_u + (1 - p) \cdot C_d \right] $$

Where:

• \( C \) = current option price
• \( r \) = risk-free interest rate
• \( \Delta t \) = time increment
• \( p \) = risk-neutral probability
• \( C_u \) and \( C_d \) = the option values at the up and down nodes respectively

Risk-Neutral Probability

Risk-neutral probability \( p \) is given by:

$$ p = \frac{(1 + r) - d}{u - d} $$

This ensures that the expected value of the future cash flows, discounted at the risk-free rate, represents the fair value of the option.

Types and Variations

European vs American Options

European Options: These can only be exercised at expiration.

American Options: These can be exercised at any point up to and including the expiration date.

The Binomial Option Pricing Model can be adapted to value both European and American options.

Multi-period Model

The binomial model can be extended to multiple periods, where each period represents a potential change in the asset price. This results in a binomial tree with several layers, providing a more granular approximation of the option’s value.

Special Considerations

Assumptions and Limitations

• The price changes of the underlying asset follow a binomial distribution.
• The model assumes no transaction costs or taxes.
• The model requires a known risk-free rate and constant volatility over the life of the option.

These assumptions may limit the model’s applicability to certain market conditions.

Practical Examples

Step-by-Step Calculation

Suppose a stock is currently priced at $100, and it can either go up by 10% or down by 10%. The risk-free interest rate is 5% per annum, and the option maturity is one period.

Here’s a simplified step-by-step calculation:

1. Determine \( u \) and \( d \):
   $$ u = 1.10 $$
   $$ d = 0.90 $$
2. Calculate the risk-neutral probability \( p \):
   $$ p = \frac{(1 + 0.05) - 0.90}{1.10 - 0.90} = 0.75 $$
3. Compute the option’s values at the nodes.

The iterative procedure continues until the initial node’s value is found.

Historical Context

The Binomial Option Pricing Model was developed in the late 1970s. It offers a simpler alternative to the Black-Scholes model, especially for American options, as it more easily accounts for the option’s early exercise feature.

Applicability and Comparisons

Comparison with Black-Scholes Model

The Binomial Model divides the time to expiration into discrete intervals, while the Black-Scholes Model assumes continuous time. The binomial model is more versatile for American options and provides a more intuitive method to include varying interest rates, dividends, and other features.

Related Terms and Concepts

• Black-Scholes Model: A continuous-time model for options pricing.
• Delta Hedging: A method of managing the risk of an options position by adjusting the quantity of the underlying asset.
• Monte Carlo Simulation: A computational algorithm that uses random sampling to obtain numerical results, often used in options pricing.

FAQs

How does the binomial model handle dividends?

Dividends can be incorporated by adjusting the stock price downward at the expected dividend payout dates.

Can the binomial model price exotic options?

Yes, the flexibility of the binomial model allows it to be adapted for various types of exotic options.

References

• Cox, J.C., Ross, S.A., & Rubinstein, M. (1979). “Option Pricing: A Simplified Approach”. Journal of Financial Economics.
• Hull, J.C. (2020). “Options, Futures, and Other Derivatives”.

Summary

The Binomial Option Pricing Model is a powerful and flexible method for valuing options. By constructing a binomial tree, it allows for the iterative calculation of an option’s fair value, accommodating various market conditions and option features effectively.