What is Binomial Option Pricing Model?
The binomial option pricing model values an option by modeling possible share-price paths as a tree of up and down moves over discrete time steps. At each node, the model calculates the option’s expected payoff, then discounts those payoffs back to today using risk-neutral probabilities.
How It Works
- Divide the life of the option into a number of equal time steps.
- At each step, the share price either moves up by a factor u or down by a factor d.
- Compute the option’s intrinsic value at each terminal node.
- Roll back through the tree using risk-neutral probabilities to derive today’s option value.
Saudi Context
Saudi banks and financial advisors use binomial models when valuing employee stock options with American-style early exercise features for IFRS 2 disclosures.
Example
A one-year option with a strike of SAR 100 on a share that can move up 20 percent or down 20 percent each step can be valued by working backward through a two-step tree and discounting at the risk-free rate.