Binomial options pricing model

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BOPM redirects here; for other uses see BOPM (disambiguation).

In finance, the binomial options pricing model (BOPM) provides a generalizable numerical method for
the valuation of options. The binomial model was first proposed by Cox, Ross and Rubinstein in 1979.[1]
Essentially, the model uses a discrete-time (lattice based) model of the varying price over time of the
underlying financial instrument. In general, binomial options pricing models do not have closed-form
solutions.

Contents
1 Use of the model
2 Method
2.1 STEP 1: Create the binomial price tree
2.2 STEP 2: Find Option value at each final node
2.3 STEP 3: Find Option value at earlier nodes
2.3.1 Discrete dividends
3 Relationship with BlackScholes
4 See also
5 References
6 External links
6.1 Discussion
6.2 Variations
6.3 Computer implementations

Use of the model

The Binomial options pricing model approach is widely used as it is able to handle a variety of conditions
for which other models cannot easily be applied. This is largely because the BOPM is based on the
description of an underlying instrument over a period of time rather than a single point. As a consequence,
it is used to value American options that are exercisable at any time in a given interval as well as Bermudan
options that are exercisable at specific instances of time. Being relatively simple, the model is readily
implementable in computer software (including a spreadsheet).

Although computationally slower than the BlackScholes formula, it is more accurate, particularly for
longer-dated options on securities with dividend payments. For these reasons, various versions of the
binomial model are widely used by practitioners in the options markets.
For options with several sources of uncertainty (e.g., real options) and for options with complicated features
(e.g., Asian options), binomial methods are less practical due to several difficulties, and Monte Carlo option
models are commonly used instead. When simulating a small number of time steps Monte Carlo simulation
will be more computationally time-consuming than BOPM (cf. Monte Carlo methods in finance). However,
the worst-case runtime of BOPM will be O(2n), where n is the number of time steps in the simulation.
Monte Carlo simulations will generally have a polynomial time complexity, and will be faster for large
numbers of simulation steps. Monte Carlo simulations are also less susceptible to sampling errors, since
binomial techniques use discrete time units. This becomes more true the smaller the discrete units become.

Method
The binomial
pricing model traces
the evolution of the
option's key
underlying variables
in discrete-time.
This is done by
means of a binomial
lattice (tree), for a
number of time
steps between the
valuation and
expiration dates.
Each node in the
lattice represents a
possible price of the
underlying at a
given point in time.

Valuation is performed iteratively, starting at each of the final nodes (those that may be reached at the time
of expiration), and then working backwards through the tree towards the first node (valuation date). The
value computed at each stage is the value of the option at that point in time.

Option valuation using this method is, as described, a three-step process:

1. price tree generation,

2. calculation of option value at each final node,
3. sequential calculation of the option value at each preceding node.

STEP 1: Create the binomial price tree

The tree of prices is produced by working forward from valuation date to expiration.
At each step, it is assumed that the underlying instrument will move up or down by a specific factor ( or
) per step of the tree (where, by definition, and ). So, if is the current price, then in
the next period the price will either be or .

The up and down factors are calculated using the underlying volatility, , and the time duration of a step, ,
measured in years (using the day count convention of the underlying instrument). From the condition that
the variance of the log of the price is , we have:

Above is the original Cox, Ross, & Rubinstein (CRR) method; there are other techniques for generating the
lattice, such as "the equal probabilities" tree. The Trinomial tree is a similar model, allowing for an up,
down or stable path.

The CRR method ensures that the tree is recombinant, i.e. if the underlying asset moves up and then down
(u,d), the price will be the same as if it had moved down and then up (d,u) here the two paths merge or
recombine. This property reduces the number of tree nodes, and thus accelerates the computation of the
option price.

This property also allows that the value of the underlying asset at each node can be calculated directly via
formula, and does not require that the tree be built first. The node-value will be:

Where is the number of up ticks and is the number of down ticks.

STEP 2: Find Option value at each final node

At each final node of the tree i.e. at expiration of the option the option value is simply its intrinsic, or
exercise, value.

Max [ ( ), 0 ], for a call option

Max [ ( ), 0 ], for a put option:

Where is the strike price and is the spot price of the underlying asset at the period.

STEP 3: Find Option value at earlier nodes

Once the above step is complete, the option value is then found for each node, starting at the penultimate
time step, and working back to the first node of the tree (the valuation date) where the calculated result is
the value of the option.

In overview: the binomial value is found at each node, using the risk neutrality assumption; see Risk
neutral valuation. If exercise is permitted at the node, then the model takes the greater of binomial and
exercise value at the node.
The steps are as follows:

(1) Under the risk neutrality assumption, today's fair price of a derivative is equal to the expected value of
its future payoff discounted by the risk free rate. Therefore, expected value is calculated using the option
values from the later two nodes (Option up and Option down) weighted by their respective probabilities
probability p of an up move in the underlying, and probability (1-p) of a down move. The expected
value is then discounted at r, the risk free rate corresponding to the life of the option.

The following formula to compute the expectation value is applied at each node:

Binomial Value = [ p Option up + (1-p) Option down] exp (- r t), or

where
is the option's value for the node at time ,

is chosen such that the related binomial distribution simulates the geometric

Brownian motion of the underlying stock with parameters r and ,

is the dividend yield of the underlying corresponding to the life of the option. It follows that in a
risk-neutral world futures price should have an expected growth rate of zero and therefore we can
consider for futures.

Note that for to be in the interval the following condition on has to be satisfied

(Note that the alternative valuation approach, arbitrage-free pricing, yields identical results; see
delta-hedging.)

(2) This result is the Binomial Value. It represents the fair price of the derivative at a particular point in
time (i.e. at each node), given the evolution in the price of the underlying to that point. It is the value of the
option if it were to be heldas opposed to exercised at that point.

(3) Depending on the style of the option, evaluate the possibility of early exercise at each node: if (1) the
option can be exercised, and (2) the exercise value exceeds the Binomial Value, then (3) the value at the
node is the exercise value.

For a European option, there is no option of early exercise, and the binomial value applies at all
nodes.
For an American option, since the option may either be held or exercised prior to expiry, the value at
each node is: Max (Binomial Value, Exercise Value).
 For a Bermudan option, the value at nodes where early exercise is allowed is: Max (Binomial Value,
Exercise Value); at nodes where early exercise is not allowed, only the binomial value applies.

In calculating the value at the next time step calculatedi.e. one step closer to valuationthe model must
use the value selected here, for Option up/Option down as appropriate, in the formula at the node.

The following algorithm demonstrates the approach computing the price of an American put option,
although is easily generalized for calls and for European and Bermudan options:

function americanPut(T, S, K, r, sigma, q, n) {

' T... expiration time
' S... stock price
' K... strike price
' n... height of the binomial tree

deltaT := T / n;
up := exp(sigma * sqrt(deltaT));

p0 := (up * exp(-r * deltaT) - exp(-q * deltaT)) * up / (up^2 - 1);

p1 := exp(-r * deltaT) - p0;

' initial values at time T

for i := 0 to n {
p[i] := K - S * up^(2*i - n);
if p[i] < 0 then p[i] := 0;
}

' move to earlier times

for j := n-1 down to 0 {
for i := 0 to j {
p[i] := p0 * p[i] + p1 * p[i+1]; ' binomial value
exercise := K - S * up^(2*i - j); ' exercise value
if p[i] < exercise then p[i] := exercise;
}
}

return americanPut := p[0];

}

Discrete dividends

In practice, the use of continuous dividend yield, , in the formula above can lead to significant mis-pricing
of the option near an ex-dividend date. Instead, it is common to model dividends as discrete payments on
the anticipated future ex-dividend dates.

To model discrete dividend payments in the binomial model, apply the following rule:

At each time step, , calculate , for all where is the present value of
the -th dividend. Subtract this value from the value of the security price at each node ( , ).

Relationship with BlackScholes

Similar assumptions underpin both the binomial model and the BlackScholes model, and the binomial
model thus provides a discrete time approximation to the continuous process underlying the BlackScholes
model. In fact, for European options without dividends, the binomial model value converges on the Black
Scholes formula value as the number of time steps increases. The binomial model assumes that movements
in the price follow a binomial distribution; for many trials, this binomial distribution approaches the normal
distribution assumed by BlackScholes.

In addition, when analyzed as a numerical procedure, the CRR binomial method can be viewed as a special
case of the explicit finite difference method for the BlackScholes PDE; see Finite difference methods for
option pricing.

In 2011, Georgiadis shows that the binomial options pricing model has a lower bound on complexity that
rules out a closed-form solution.[2]

See also
Trinomial tree, a similar model with three possible paths per node.
Tree (data structure)
BlackScholes, binomial lattices are able to handle a variety of conditions for which BlackScholes
cannot be applied.
Monte Carlo option model, used in the valuation of options with complicated features that make them
difficult to value through other methods.
Real options analysis, where the BOPM is widely used.
Quantum finance, quantum binomial pricing model.
Mathematical finance, which has a list of related articles.
Employee stock option #Valuation, where the BOPM is widely used.
Implied binomial tree

References
1. ^ Cox, J. C.; Ross, S. A.; Rubinstein, M. (1979). "Option pricing: A simplified approach". Journal of Financial
Economics 7 (3): 229. doi:10.1016/0304-405X(79)90015-1 (http://dx.doi.org/10.1016%2F0304-
405X%2879%2990015-1).
2. ^ Georgiadis, Evangelos (2011). "Binomial options pricing has no closed-form solution"
(http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1773170). Algorithmic Finance (IOS Press) 1 (1): 1316.
doi:10.3233/AF-2011-003 (http://dx.doi.org/10.3233%2FAF-2011-003).

Richard J. Rendleman, Jr. and Brit J. Bartter. 1979. "Two-State Option Pricing". Journal of Finance
24: 1093-1110. doi:10.2307/2327237 (http://dx.doi.org/10.2307%2F2327237)

External links
Discussion

The Binomial Model for Pricing Options (http://www.sjsu.edu/faculty/watkins/binomial.htm), Prof.

Thayer Watkins
Binomial Method (Cox, Ross, Rubinstein) (http://www.global-derivatives.com/options/european-
options.php#binomial), global-derivatives.com
Binomial Option Pricing
(http://faculty.darden.virginia.edu/conroyb/derivatives/Binomial%20Option%20Pricing%20_f-
0943_.pdf) (PDF), Prof. Robert M. Conroy
Options pricing using a binomial lattice (http://www.iassa.co.za/articles/048_1998_05.pdf), The
Investment Analysts Society of Southern Africa
Convergence of the Binomial to the BlackScholes Model
(http://www.bus.lsu.edu/academics/finance/faculty/dchance/Instructional/TN00-08.pdf) PDF (143 KB),
Prof. Don M. Chance
Binomial Option Pricing Model (http://demonstrations.wolfram.com/BinomialOptionPricingModel/)
by Fiona Maclachlan, The Wolfram Demonstrations Project
On the Irrelevance of Expected Stock Returns in the Pricing of Options in the Binomial Model: A
Pedagogical Note (http://ssrn.com/abstract=844104) by Valeri Zakamouline

Variations

American and Bermudan options

Pricing Bermudan Options (http://www.cs.umanitoba.ca/~tulsi/Final/May27/XiaoLiuFinal.ps.pdf),

umanitoba.ca
Option Pricing: Extending the Basic Binomial Model
(http://www.savvysoft.com/display_whitepaper.cgi?class=whitepaper&doc=advanced.htm), Rich
Tanenbaum

Other tree structures

Extending and simulating the quantum binomial options pricing model

(http://mspace.lib.umanitoba.ca/handle/1993/3154), Keith Meyer
A Synthesis of Binomial Option Pricing Models for Lognormally Distributed Assets
(http://www.bus.lsu.edu/academics/finance/faculty/dchance/Research/ASynthesisofBinomialOptionP
ricingModels.pdf), Don M. Chance
Binomial and Trinomial Trees - overview (http://www.sitmo.com/article/binomial-and-trinomial-
trees), The Quant Equation Archive, sitmo.com
Fixed income derivatives

Binomial Pricing of Interest Rate Derivatives

(http://www.bus.lsu.edu/academics/finance/faculty/dchance/Instructional/TN97-14.pdf) PDF (76.3 KB),
Don M. Chance
Binomial Models for Fixed Income Analytics (http://pages.stern.nyu.edu/~dbackus/3176/adlec3.pdf),
David Backus and Stan Zin
Binomial Term Structure Models (http://finance.wharton.upenn.edu/~benninga/mma/MiER73.pdf),
Simon Benninga and Zvi Wiener

Computer implementations

Spreadsheets

American Options - Binomial Method (http://www.global-derivatives.com/xls/American-

Binomial.xls), global-derivatives.com
European Options - Binomial Method (http://www.global-derivatives.com/xls/European-
Binomial.xls), global-derivatives.com
Tutorial to create binomial trees in Excel (http://www.youtube.com/watch?v=fysNDIXSB2k)
Tutorial to simulate stock prices with binomial model in Excel (http://www.youtube.com/watch?
v=cuviNtMMQsA)

Desktop pricer

Fairmat, free-to-use software which implements various binomial trees option pricing through a plug-
in (http://www.fairmat.com/plugins/000017).

Online pricer

Online european and american options pricing - Binomial Methods (Tian, CRR, Risk Neutral)
(http://www.pricing-option.com/tree.aspx), pricing-option.com
Binomial OptionsCalc Online (http://www.fintools.com/resources/online-calculators/options-
calcs/binomial/), fintools.com
Binomial Calculator (http://www.ivolatility.com/calc/), ivolatility.com

Programming languages

C (http://home.comcast.net/~laghan3/options.htm)
Fortran (http://www.stat.rice.edu/~dobelman/download/bsopm.html)
Mathematica (http://finance.wharton.upenn.edu/~benninga/mma/MiER63.pdf)
S-Plus (http://www.stat.rice.edu/~dobelman/download/bsopm.html)
 Python: implementation
(http://code.google.com/p/quantandfinancial/source/browse/trunk/quant/options.py), article
(http://www.quantandfinancial.com/2012/11/cox-ross-rubinstein-option-pricing-model.html)

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