Binomial Option Pricing Model
The Binomial Option Pricing Model, which makes use of iterative process and allows specifications of specific intervals in the period between the date of option expiration and the valuation date is termed as the binomial option pricing model. This model was found by Cox, et al in the year 1979.
The model is proved to be accurate and has brought reduction in chances of rate changes, as well as arbitrage. It shortens the period of the option and works on the assumption of perfectly efficient market. With such simplified assumptions, it can result in a mathematical option valuation at different points.
How Does Binomial Option Pricing Model Applied in Options Market?
The approach followed by this model is a risk-neutral approach. The assumption on which it is based is that until the expiry date of the option (till the option becomes worthless); the underlying asset rates would either rise or fall.
The model has some unique benefits due to the simplified and repetitive approach. For example, due to the possibility of providing valuations at different points during a particular period, it is useful for America options where the investor can exercise the option anytime before expiration date arrives. It is much simpler than some of the models like the Black Scholes model, hence implementation becomes easy.
Tags: Binomial Option Pricing Model, Black Scholes model, risk-neutral approach
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