Question

This is a continuation of our last discussion in some ways. In the previous discussion we covered the options used as speculating and hedging. A good and simple way to price an option is a Binomial Tree. The idea is that each branch involves a random walk. It’s like flipping a coin heads or tails and the next time it all resets again to either heads or tails. The Binomial Tree and its construction can use one and two period values of those options on either stocks commodities or futures. This section includes the mechanics of pricing these binomial options. In the next module after this one we will discuss the valuation in more detail. Up to now we looked at pricing an option to other options. We now look at the pricing of an option relative to the underlying asset. There are European options which only can be exercised only at expiration and American options (most popular) that can be exercised any time up to expiration.

Question(s) of Discussion. You can discuss any ONE or more of the following.

1. What is your opinion of the Binomial Tree and as far as its relevance to valuations of options.
2. Which are more important in your opinion and why; one period and two period Binomial Trees and why.
3. Try to find and add to the discussion if you can using a real company option example of an American or European option and discuss its valuation and if you think its fairly priced and why.

Answer 1

What are your opinion of the binomial tree as far as its relevence to valuation of option.

Binomial option is one the most important concepts in modern financial theory. The relevence of using it for valuation of option is dicussed below-

1. Multi- period view- the binomial model provides a multi period view of the underlying asset price as well as the price of the option. it allows the calculation of the asset and the option for multiple periods along with the range of possible results foreach period. This helps us to visualise the change in asset price from period to period and evaluate the option based on the decisions made at different points in time.

2. Transpirancy- closely related to the multi-period reviews is the ability of the binomial model to provide transpirancy into the underlying value of the assets and the option as time progresses.

3. Incorporating probabilities- the basic method of calculating the binomial options model is to use the same probability each period for sucess and failure until the option expires. However, a trader can incorporate different probabilities for each period based on new information obtained as time passes.

4. Bottom line- the binomial tree gives amore detailed view by allowing multi-period views of the underlying asset price and the price od the option for the multiple periods as well as the range of possible results of each period. This make the binomial tree model become a broader range of applications ,more intuitive and is easier to use.