Chapter 4: The Binomial Model: A Simplified Analysis

The binomial option valuation model is an extremely simple model for pricing of options. The model traces the evolution of the underlying asset price in discrete time units. The price of the underlying asset, instead of changing in a continuous manner, takes a leap to one of the two different new values, up and down, at the next time point. Consequently, the valuation of options relies on an iterative process, where for each iteration the only two possible outcomes are up and down. For each iteration, the model uses the same probabilities for up and down. The model is analytically simple and easy to understand. The simple structure of the model becomes helpful in administering the valuation of options under the possibility of early exercise.