University of Arkansas System
Type of paper: Thesis/Dissertation Chapter
Binomial and Black and Scholes Pricing models
The binomial and the Black and Schole models are option valuing models, the Binomial model involves determining the value of options using a tree like format whereby the value of the option is determined by the expiration time period of the option and volatility, for the Black and Schole model the value of options is determined by simply getting a derivative that helps get the discount rates of options. Binomial pricing model: The binomial pricing model was introduced by Ross, Cox and Rubinstein in 1979; it provides a numerical method, in which valuation of options can be undertaken.
Application: This model breaks down the option into many potential outcomes during the time period of the option, this steps form a tree like format where by the model assumes that the value of the option will rise or go down, this value is calculated and it is determined by the expiration time and volatility. Finally at the end of the tree of the option the final possible value is determined because the value is equal to the intrinsic value. Assumptions:
• The model also assumes that the market is efficient in that people cannot predict the direction of change in the stock prices. • The interest rates are constant and known and therefore they do not change in the time we consider an option. • The model assumes that there are no dividends paid during the period in which one considers the option. • The model assumes that the returns on the stocks are normally distributed. • It also assumes that no commission is paid when buying or selling stock.