Binomial Option Pricing Model (For Excel)

Binomial Option Pricing Model (For Excel)

The Binomial Option Pricing Model is an options valuation method developed by Cox in 1979.  It is a very simple model that uses an iterative procedure to price options, allowing for the specification of nodes, or points in time, during the time span between the valuation date and the option’s expiration date. When compared to the Black Scholes model and other complex models, the binomial option pricing model is mathematically simple and easy to use.

The model  lowers the possibilities of price changes and is based on the concept of no arbitrage, it assumes a perfectly efficient market, and shortens the duration of the option. Under these simplifications, it is able to provide a mathematical valuation of the option at each node specified.

Binomial Option pricing model is an important topic for the FRM Part 1 exam. There are both conceptual and numerical questions in the exam to test this topic. Here, we will discuss various concepts related to binomial option pricing model.

Assumptions in Binomial Option Pricing Model

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

In detail, the assumptions in binomial option pricing models are as follows:

1. There are only two possible prices for the underlying asset on the next day. From this assumption, this model has got its name as Binomial option pricing model (Bi means two)
2. The two possible prices are the up-price and down-price
3. The underlying asset does not pay any dividends
4. The rate of interest (r) is constant throughout the life of the option
5. Markets are frictionless i.e. there are no taxes and no transaction cost
6. Investors are risk neutral i.e. investors are indifferent towards risk

Binomial Option Pricing Model Advantages

1. Binomial option pricing models are mathematically simple to use.
2. Binomial option pricing model is useful for valuing American options in which the option owner has the right to exercise the option any time up till expiration.
3. Binomial option model is also useful for pricing Bermudan options which can be exercised at various points during the life of the option.

Binomial Option Pricing Model Limitations

One major limitation of the binomial option pricing model is it is slow speed and complex. Complexity of computation is increased twofold in multi -period binomial option pricing model.

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