Binomial Option Pricing Model

 The Simplest method to price the options is use a Binomial Option Pricing Model
 Under the binomial model, we consider that the price of the underlying asset will either go up or down in the
period

the kinds of Binomial Option

 European Call and Put Option

 American Call and Put Option

One Period European Call Option

A stock price is currently $40. It is known that at the end of 1 month it will be either $42 or $38. The risk-free interest
rate is 8% per annum with continuous compounding. What is the value if a 1-month European call option with a strike
price of $39?

Solution

So = $40;
So u= $42
So u= $42;

So d=$38 So = $40
r= 8%

K=$39 So d=$38

T= 1 month = 1/12 year.

f u=Max ( S t −K , 0 )=Max ( 42−39,0 )=$ 3

f d =Max ( S t−K , 0 ) =Max (38−39,0 ) =$ 0

So u= $42

f u=$ 3
So = $40

f So d=$38

f d =$ 0
 rT
e −d
P= P So u= $42
u−d
S o u 42
u= = =1.05 So = f u=$ 3
So 40 $40
So d 38
d= = =0.95
S o 40 f
1-P So d=$38
1
0.08( )
12
e −0.95
P= =0.5669 f d =$ 0
1.05−0.95

1−P=1−0.5669=0.4331

−rT
f =[P f u+ (1−P ) f d ]e

f =[0.5669 x 3+0.4331 x 0]e−0.08 /12

0.5669 So u= $42
f =$ 1.6893

So = $40 f u=$ 3

f=1.6893
0.4331 So d=$38

f d =$ 0

European Put Option

A stock price is currently $50. It is known that at the end of 6 months it will be either $45 or $55. The risk-free interest
rate is 10% per annum with continuous compounding. What is the value if a 6-month European put option with a strike
price of $50?

Solution

So = $50; So u= $55
So u= $55; So = $40
So d=$45 So d=$45

r= 10%

K=$50

T= 6 month = 1/2 year.

f u=Max ( S ou−K , 0 ) =Max (50−55,0 )=$ 0

f d =Max ( S od−K , 0 ) =Max ( 50−45,0 )=$ 5

So u= $55

So = $50 f u=$ 0

F=?
So d=$45

f d =$ 5

P=0.6751 So u= $55
S o u 55
u= = =1.1
So 50
So = $50 f u=$ 0
So d 45
d= = =0.9
S o 50
F=?
r= 10%, T= 0.5 Year
So d=$45
e rT −d 0.1 x 0.5 1−P=0.3249
P= = P= e −0.9
=0.6751
u−d 1.1−0.9
f d =$ 5
1−P=1−0.6751=0.3249

−rT
f =[P f u+ (1−P ) f d ]e
−0.1 x0.5 So u= $55
f =[0.6751 x 0+ 0.3249 x 0]e P=0.6751
f =[ 0+1.6243 ] x 0.9512
f u=$ 0
f =$ 1.545 0
So = $50
F=?
1−P=0.3249 So d=$45

f d =$ 5

European Call Option Two Period

A stock price is currently $100. Over each of the next two 6-month periods it is expected to go
up by 10% or down by 10%. The risk-free interest rate is 8% per annum with continuous
compounding. What is the value of a 1-year European call option with a strike price of $100?
Given
So = $100;

Price = ± $ 10 % ;

r= 8%

n= 2(each of 6 month)

K=$100

T= 1 year

So uu= $121
P
f uu=21

P So u= $110
1-P
fu So ud= $99
So = $100
P
f ud=0
f
1-P So d=$90

fd
1-P So dd= $81
f uu=Max ( S t− K ,0 ) f dd=0

f ud=Max ( St −K , 0 )

f dd=Max ( St −K , 0 )

e rT −d 1−P=1−0.7041=0.2959
P=
u−d
S o u 110
u= = =1.1 f =¿ ¿
So 100
2 −
f =(0.7041 ¿ ¿ 2× 21+ 2× 0.7041× 0.2959× 0+0.2959 ×0) e

So d 90 f =(10.41089+ 0+0)× 0.923116

d= = =0.9
S o 100 f =$ 9.10466
e 0.8 x0.5 −0.9
P= =0.7041
1.1−0.9

So u= $121
 0.7041 f uu=21

0.7041 So u= $110
fu 0.2959 So ud= $99
So = $100
f ud=0
f=9.10466 0.7041
0.2959 So d=$90

fd
0.2959 So dd= $81

f dd=0

European Put Option Two Period

A stock price is currently $100. Over each of the next two 6-month periods it is expected to go
up by 10% or down by 10%. The risk-free interest rate is 8% per annum with continuous
compounding. What is the value of a 1-year European call option with a strike price of $100?
Given
So = $100;

Price = ± $ 10 % ;

r= 8%

n= 2(each of 6 month)

K=$100

T= 1 year

So u= $121

f uu=0
So u= $110
fu So ud= $99
So = $100
f ud=1
f
So d=$90
So dd= $81
fd
f dd=19
f uu=Max ( S t− K ,0 )

f ud=Max ( St −K , 0 )

f dd=Max ( St −K , 0 )

e rT −d S o u 110
P= u= = =1.1
u−d So 100
 So d 90
d= = =0.9
S o 100
f =¿ ¿
0.8 x0.5
e −0.9 f =(0.7041 ¿ ¿ 2× 0+2 ×0.7041 ×0.2959 ×0+ 0.2959 ×19) e
2 −
P= =0.7041
1.1−0.9
f =(0+0.4166+1.6635)×0.923116
1−P=1−0.7041=0.2959
f =$ 1.9202

So u= $121
0.7041 f uu=0

0.7041 So u= 0.2959
$110
fu So ud= $99
So = $100
0.7041
f ud=1
f=1.9202
0.2959 So d=$90

fd
0.2959 So dd= $81

f dd=19

American Call Option Two Period

A stock price is currently $100. Over each of the next two 6-month periods it is expected to go
up by 10% or down by 10%. The risk-free interest rate is 8% pet annum with continuous
compounding. What is the value of a 1-Year American call option with a strike price of $100?
Given
So = $100;
121
Price = ± $ 10 % ;
P f uu=$ 21
r= 8%

n= 2(each of 6 month)

K=$100 110
1-P 99
T= 6 months = 0.5
f ud=$ 0

So u= $121
P
 f uu=21
P So u= $110 1-P

fu So ud= $99
So = $100 P
f ud=0
f
1-P So d=$90

So dd= $81
fd 1-P
f dd=0

0.8 x0.5
e −0.9
P= =0.7041
1.1−0.9
1−P=1−0.7041=0.2959

f u=(P f uu+ ( 1−P ) f ud ) e−rT

f u=( 0.7041× 21+ 0.2959× 0)e−0.08× 0.5

f u=$ 14.2063

f u=Max ( S t −K ,14.2063 )

f u=Max ( 110−100,14.2063 )

f u=Max ( 10 , $ 14.2063 )

f u=$ 14.206

−rT
f =(P f u + ( 1−P ) f d )e
−0.08× 0.5
f =(0.7041× 14.2063+ 0.2959 ×0)e

f =$ 9.6105

So u= $121
f uu=21
So u= $110
f u=$14.2063
So = $100 So ud= $99
f ud=0
f=9.6105 So d=$90

f d =0
So dd= $81
American Put Option Two Period f dd=0
A stock price is currently $100. Over each of the next two 6-month periods it is expected to go
up by 10% or down by 10%. The risk-free interest rate is 8% per annum with continuous
compounding. What is the value of a 1-Year American call option with a strike price of $100?

Given
So = $100;
121
Price = ± $ 10 % ;
P f uu=$ 0
r= 8%

n= 2(each of 6 month)

K=$100 110
1-P 99
T= 6 months = 0.5
f ud=$ 1

So u= $121
f uu=0
So u= $110
fu So ud= $99
So = $100
f ud=1
f
So d=$90

So dd= $81
fd

f dd=19

u=1.1, d=0.9
e 0.8 x0.5 −0.9
P= =0.7041
1.1−0.9
1−P=1−0.7041=0.2959 f u=Max ( S T −K , 0.2843 )
−rT
f u=(P f uu + ( 1−P ) f ud ) e f u=Max ( 110−100 , $ 0.2843 )
−0.08 × 0.5
f u=( 0.7041× 0+0.2959 ×1) e f u=Max ( 10 , $ 0.2843 )
f u=$ 0.2843 f u=$ 0.2843

f d =( P f ud + (1−P ) f dd )e
−rT
f d =Max ( S T −K , 0 )

f d =(0.7041 ×1+0.2959 ×19) e

−0.08 ×0.5
f d =Max ( 100−90 , $ 6.07814 )

f d =$ 6.07814 f d =Max ( 10 , $ 6.07814 )

f d =$ 10

So uu= $121
So u= $110
 f uu=0

f u=$0.2843
So = $100 So ud= $99
f ud=1
f So d=$90

f d =10
So dd= $81

f dd=19

So u= $110
f u=$0.2843
So = $100

f So d=$90

f d =10

−rT
f =(P f u + ( 1−P ) f d )e

f =(0.7041× 0.2843+0.2959 ×10) e−0.08× 0.5

f =$ 3.0353