This computational mannequin makes use of an iterative process, permitting for the specification of nodes in the course of the time between the valuation date and the choice’s expiration date. At every node, the mannequin assumes the underlying asset can transfer to one in every of two doable costs, making a binomial tree. By working backward from the choice’s expiration worth at every remaining node and making use of a risk-neutral chance at every step, the mannequin determines the choice’s theoretical worth on the preliminary node. A easy instance may contain a inventory which may both improve or lower by a sure share at every step. The mannequin calculates the choice’s payoff at every remaining node primarily based on these value actions after which works backward to find out the present possibility value.
Its energy lies in its means to deal with American-style choices, which could be exercised earlier than expiration, not like European-style choices. Moreover, it may possibly accommodate dividends and different company actions that impression the underlying asset’s value. Traditionally, earlier than widespread computational energy, this methodology offered a sensible various to extra complicated fashions just like the Black-Scholes mannequin, particularly when coping with early train options. It stays a invaluable software for understanding possibility pricing ideas and for valuing choices on property with non-standard traits.
