| Binomial options pricing model or BOPM, as it is | | | | first node. The value that you will calculate in each |
| popularly known is a generalized numerical method | | | | node of the binomial tree is the value of the option |
| that is used for the valuation of options. This method | | | | at that point of time. |
| was proposed by Rubinstein, Cox and Ross. This | | | | BOPM follows a three step process. In the first step, |
| method is popular in the sense that it can be used | | | | which is binomial tree generation, a tree comprised of |
| for variety of conditions, while the other numerical | | | | prices is produced by working forward the date of |
| methods have limited use. The main reason why it | | | | valuation to expiration. It is assumed that at each |
| can be used in varied situations is that it is based on | | | | step the value of underlying instrument is either |
| the underlying instrument spread over a period of | | | | moving down or up by a specific factor. The down |
| time rather than a single point of time. It is slower, | | | | and up factors are calculated using underlying |
| but much more accurate than any other method. | | | | volatility. The next step is to find the value of option |
| This method traces the evolution of options | | | | at each final node. The option value which is obtained |
| underlying variable spread over a period of time. This | | | | is called the exercise or intrinsic value. The third step |
| is done by using a binomial tree or binomial lattice. | | | | is to find the value of options at earlier nodes, by |
| Each node in the binomial tree or lattice represents | | | | moving backwards from the final nodes. |
| price of the underlying at a single point of time. The | | | | Please check the post nine ways for option pricing |
| valuation is performed iteratively, i.e., it starts from | | | | for a binomial tree implementation. |
| the final node and goes backwards till it reaches the | | | | |