Chris Hebert 10/27/10

History of The Binomial Option Pricing Model

Cox-Ross-Rubinstein 1979 After Black-Scholes (1973) After Monte Carlo Methods

What is it?

The Binomial Option Pricing Model is essentially a tree that is constructed to show possible values that an underlying asset can take and the resulting value of the option at these values.

One Simplifying Assumption

The Binomial Option Pricing Model makes an assumption that over a certain time period, the underlying can only do one of two things: go up, or go down.

Up and down by how much?

Lets call the upward movement u, and the downward movement d. Intuitively, the magnitude of this movement should be based on volatility and the size of the time interval. Cox-Ross-Rubinstein found u and d to be:

How can we assume only up or down?

We can assume that the stock can only go up or down because we use a large number of short time periods. With a small number of time intervals, the model only considers a few possible final outcomes. As we increase the number of time intervals, more possible final outcomes are considered and accuracy increases.

Example

S=90.00 K=100.0 T= 1 = .3 r= .01 t= .1

How did we construct that?

Step 1: Create the Binomial Price Tree Step 2: Calculate the Payoff at time T for all nodes Step 3: Pull back calculation to calculate value of option at each node from time T to time 0.

Important Observation
Because of the nature of stock movements, the binomial lattice is recombining. Going up then down is the same as going down then up. This enables us to make fewer node calculations, expediting process.

Step 1: Create the Binomial Price Tree

We know the current stock price (S0) Multiply (S0) by u to find the stock price at time t=1 for an upward movement Multiply (S0) by d to find the stock price at time t=1 for a downward movement To find S at any node multiply (S0)(u)n(d)t-n where n= the number of upward movements

Step 2: Calculate the Payoff at time T for all nodes

Plug in the stock price at each final node into the payoff formula to calculate the value of the option at maturity These are all of the possible payoffs of an option.

Step 3: Pull back calculation

Work from maturity backwards to present Fair price of option today is equal to the expected payoff of the option discounted by the riskless interest rate Take the values of two possibilities the option can attain at time t (up or down) and pull back the value for the option at time t-1

Step 3 (continued)
Let C be the value of the option at time t and node i Factor in riskless interest rate to the probability that the option goes up or down For p we use .5 to assume random movements of the stock, up and down

Inputs needed
S0= Stock price at time t=0 K= Strike Price (for payoff) T= Time to expiry = volatility r= riskless interest rate t= change in time; size of each step in tree

Example

S=90.00 K=100.0 T= 1 = .3 r= .01 t= .1

Connection to BlackScholes

The Binomial Options Pricing Method is a discrete time approximation to the continuous Black-Scholes equation for European options.

Advantages
Primary advantage of Binomial trees is that American options become much easier to price. Other advantages

Can factor in dividends

No calculus needed Easy to make a spreadsheet to find option

values

American Option Pricing

For an American Option, the value of the option at any given point is the maximum of two values:
The payoff if the option were exercised now

The pullback formulas output Note: the pullback formula takes into account American option values at future points.

Disadvantages/ Limitations

Speed
In order to have accurate results, we want to

maximize the number of time periods, but this means creating a lot of nodes which can be slow to calculate even with todays computers.

For some extreme options, like a cash or nothing, pricing can be inaccurate until a very large number of time intervals is used.

Extensions
Changing the value of p Trinomial trees

Up Down Constant

Dividends

Works Cited

Albanese, Claudio., and Giuseppe Campolieti. Advanced Derivatives Pricing and Risk Management: Theory, Tools and Hands-on Programming Application. Amsterdam ; Boston: Elsevier Academic Press, 2006. Berg, Imme van den. Principles of Infinitesimal Stochastic and Financial Analysis: . Singapore ; River Edge, N.J.: World Scientific, 2000. Daigler, Robert T. Advanced Options Trading: The Analysis and Evaluation of Trading Strategies, Hedging Tactics, and Pricing Models. Chicago, Ill.: Probus Pub. Co., 1994. http://en.wikipedia.org/wiki/Binomial_options_pricing_model http://www.hoadley.net/options/bs.htm http://www.excel-modeling.com/examples/example_007.htm http://fedc.wiwi.hu-berlin.de/xplore/tutorials/sfehtmlnode36.html