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What Is A Binomial Tree?

A binomial tree is a graphical representation used to model the evolution of an asset's price over time, particularly useful for pricing options. A binomial tree consists of nodes arranged in levels representing time steps, starting at t=0 and extending to expiration T. At each time step, the stock price can go up or down by factors u and d. Binomial trees are commonly used to price options by computing values at each node and working backward from expiration to t=0.

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17 views1 page

What Is A Binomial Tree?

A binomial tree is a graphical representation used to model the evolution of an asset's price over time, particularly useful for pricing options. A binomial tree consists of nodes arranged in levels representing time steps, starting at t=0 and extending to expiration T. At each time step, the stock price can go up or down by factors u and d. Binomial trees are commonly used to price options by computing values at each node and working backward from expiration to t=0.

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What Is a Binomial Tree?

A binomial tree is a graphical representation used in finance and mathematics to model the
evolution of an asset’s price over time. It’s particularly useful for pricing options, such as
European and American options. Here are the key points:

1. Structure:
o A binomial tree consists of nodes arranged in levels (or periods). Each level
represents a specific time step.
o The tree starts at time t=0 (the present) and extends to some final time T
(expiration or maturity).
2. Two-Step Binomial Model:
o In your homework problem, you’re dealing with a two-step binomial model.
o At each time step, the stock price can either go up or down by a certain factor.
o The tree branches out accordingly, creating a binary structure.
3. Building the Tree:
o Start with the initial stock price, denoted as S0.
o At each time step, calculate the up factor (u) and down factor (d):
 u represents the factor by which the stock price increases.
 d represents the factor by which the stock price decreases.
o Compute the stock prices at subsequent time steps based on these factors.
4. Pricing Options:
o Binomial trees are commonly used to price options.
o For example, consider a European option (like the put option in your
problem).
o At each node, compute the option value based on the stock price and the
option’s payoff function.
o Work backward from the final nodes to the initial node to find the option price
at t=0.
5. Risk-Neutral Probability:
o The risk-neutral probability (p∗) determines the likelihood of the stock price
moving up or down.
o It ensures that the expected value of the stock price matches the risk-free rate
of return.
o The formula for p∗ is:

p∗=u−derT−d

where:

 r is the per-period interest rate.


 T is the time to expiration.
 erT is the risk-free discount factor.
6. Example:
o Suppose S0=70, u=1.2, and d=0.75.
o You can compute the stock prices at each level:
 S1u=84 (up) and S1d=52.5 (down).
 At t=2, calculate S2uu, S2ud, and S2dd.
o Use the risk-neutral probability to find option prices.

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