Binomial Option Pricing Model

Basics
• It is an alternative to the Black Scholes Model.
• Can be used to value both American Style and
European style options.
• Academics credited with the model are John Cox,
Stephen Ross and Mark Rubenstein (1979) also
known as Cox-Ross-Rubenstein Model.
• A key characteristic of the Binomial Option
Pricing Model is that it models the life of the
option as a number of discrete points in time.
BASICS
 ONE PERIOD BOPM
• The one period BOPM values options using a
simple model where there are two discrete
points in time:
1. The valuation date, time 0.
2. The expiration date, T years in the future.
• The one period BOPM assumes that the
underlying asset has the following
characteristics:
 One Period BOPM
1. The underlying asset price today is S0
2. The underlying asset price will either increase
or decrease between today and the expiration
date.
3. If the underlying asset price increases, it will
increase by a factor U, where U is the value
greater than 1. Hence , if the price increases ,
its value will be:
SU = S0 . U
 One period BOPM
4. If the underlying asset price decreases , it will
decrease by a factor D, where D is a value less
than 1. Hence, if the price decreases its value
will be:
S D = S0 . D
5. U & D are inverse of each other. Hence:
D=1/U
 One period BOPM (example)
S0 = $50
U = 1.1
D = 1/1.1 = .9091
SU = $50 * 1.1 = $55
SD = $50 * (1/1.1) = $45.45
 One period BOPM
• Next, consider a call option that has a strike price
K that expires in T years.
• The long call pays a the short call a premium, c, at
initiation, and receives one of the following
payoffs at expiration:
1. If the underlying asset price increases:
max(SU – K,0) = max(S0*U – K,0)
2. If the underlying asset price decreases:
max(SD – K,0) = max(S0*D – K,0)
 One period BOPM
• Continuing the previous example, if the strike
price is $49, the long call receives one of the
following payoffs.
 Option value, one period BOPM
• The purpose of the BOPM is to solve for the
option value at initiation.
• To obtain an equation for call value we form a
portfolio consisting of the following two
positions:
1. A portion of the underlying asset
2. A short call
 Option Value, one period BOPM
• We form this portfolio as by doing so it will be
possible to structure the portfolio so that it has
the same payoff whether the underlying asset
price increases or decreases.
• If the portfolio has identical payoffs in both
scenarios it is risk free investment as its future
payoff is known with certainty.
• If the payoff is risk free we can discount it to the
present using the risk free interest rate.
• Once we do so, we can solve for the option’s
value.
 Option value, one period BOPM
• The cost at initiation and payoff at expiration
associated with a portfolio consisting of some
portion α of the underlying asset and a short
position in the call is given in fig below:
 Option value, one period BOPM
• We identify the value of α for which the two
payoffs are equal as follows:
 Option value, one period BOPM
• Since both payoffs are identical , the portfolio
is risk free and we can discount it to the
present using the risk free rate. Let’s discount
the payoff when the underlying asset price
increases:
Option value, one period BOPM
Option value, one period BOPM
Call value example
Call value example
2 period BOPM, European style option
2 period BOPM, European style option
2 period BOPM, European style option
2 period BOPM, European style option
2 period BOPM, European style option
2 period BOPM, European style option
2 period BOPM, European style option
2 period BOPM, European style option
2 period BOPM, European style option