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Binomial Method

  • Binomial method entails
  • Assuming the price of the underlying asset can take only two values in any given interval of time
  • Determining Option pay-offs at these prices
  • Replicating the same pay-offs in a package consisting of assets that can be valued
  • Alternatively, determining probability of each pay-off to arrive at a certainty equivalent expected cash-flow and discounting it to the present value at the risk-free rate
    • Risk Neutral Method

An Example


Consider a six-month European call and put option on non-dividend paying stock with identical exercise prices of Rs 85. This option is at the money. The short-term, risk-free interest rate was a bit less than 4 percent per year, or about 2 percent for six months. The stock either falls to Rs 63.75 or rises to Rs113.33 after six months. Determine their pay-offs at expiration:


The pay-offs are as follows:


Stock Price = Rs. 63.75

Stock Price = Rs.113.33

1 Call option

Rs. 0

Rs. 28.33

1 Put option

Rs. 21.25

Rs. 0


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