Binomial Trees

Binomial trees are possible graphical representation of intrinsic values that an option can take at different period of time. The value of the option varies with the change in the value of the stock in the market. The value on any of the node depends on the probability that the underlying asset value will either increase or decrease in the market at any give time period or node.

Some of the advantages in using binomial tree method are,

• It is usefulness in estimating the price of options and embedded options.  

• This method can be used in places where other models cannot be useful. This is because it is an underlying of instruments over a period of time rather than a single period.  It is used to value American options and Bermudan option which are exercised at any period of time.

• It is relatively simple compared to other models and hence can be easily developed in the computer and can be determined with the help of computer.

• Even thought the computerized methods of calculation of the values are slower in this method the estimation is accurate to a higher percentage especially when the option is for a longer duration and has a dividend payment facility available to it.

Some of the disadvantages in this method are,

• In this method the underlying asset can be worth to only one or two values alone. In reality that is not the case as asset can be worth any value at any number of times.

• The problem will arise if the asset takes into consideration only one period of time.

• It is not practically implement able for options with higher uncertainty and complicated features. Asian options cannot be implemented by using this model

Steps involved in calculation of the values of the option using binominal tree model:

• Price tree generation is the first step in this model. The binomial tree is developed for the various price and time period.

• Calculation of option value at each final mode is done using the binominal theory.  

• Sequential calculation of each option value at each preceding node.  

Binominal tree option value estimations are widely used in places where it fits in.

Questions:

• Advantage of using binominal tree model
• Disadvantage of using binominal tree model method.