Binomial Option Pricing Model

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Definition: Binomial Option Pricing Model

The binomial options pricing model (BOPM) is one of the most commonly used option pricing models. Though in calculation it is more complex as compared to the black-scholes option pricing model but is widely used due to the fact that the model describes the value of the underlying and the corresponding option value under various scenarios.

At each point, the model considers two scenarios, one is called “up” (where the value of the underlying increases) and the other one being “down” (where the value of the underlying decreases).

A binomial tree is constructed with the value at each node being the expected value using probabilities for the two scenarios. At each node where the option is excersizable, the value is taken to be             

max {current price – strike price, 0}.

Finally, using the bottom-up approach, the value that is reached at the apex node of the tree is called the option value.

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