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Binomial Model of option pricing

Binomial option pricing model is an options valuation method developed by Cox, et al, in 1979. The binomial option pricing model uses an iterative procedure, allowing for the specification of nodes, or points in time, during the time span between the valuation date and the option’s expiration date.

Like the Black-Scholes model, this model also assumes a perfectly efficient market. The binomial model takes a risk-neutral approach to valuation. It assumes that underlying security prices can only either increase or decrease with time until the option expires worthless.

Advantages of Binomial model:

  • Useful for valuing American options which allow the owner to exercise the option at any point in time until expiration.
  • The model is simple mathematically when compared to the Black-Scholes model, and is relatively easy to build and implement with a computer spreadsheet.
  • In this model it is possible to check at every point in an option’s life for the possibility of early exercise.
  • The Binomial options pricing model approach is widely used as it is able to handle a variety of conditions for which other models cannot easily be applied. This is largely because the BOPM models the underlying instrument over time – as opposed to at a particular point.
  • This model is also used to value Bermudan options which can be exercised at various points.
  • This model is considered to be more accurate, particularly for longer-dated options, and options on securities with dividend payments.

Limitations of Binomial model:

  • The main limitation of the binomial model is its relatively slow speed. Even with the power of computers available today this is not a practical solution for calculation of thousands of prices in a short span of time.
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