Introduction
This chapter examines the first of two general types of option pricing models. A model is a simplified representation of reality that uses certain inputs to produce an output, or result. An option pricing model is a mathematical formula or computational procedure that uses factors determining the option's price as inputs. The output is a theoretical fair value of the option. If the model performs as it should, the option's market price will equal the theoretical fair value. Obtaining the theoretical fair value is a process call option pricing. We begin with a simple model called the binomial option pricing model, which is more of a computational procedure than a formula.Learning Objectives
o
understand the one-period Binomial Model,
o
understand the two-period Binomial Model,
o
understand the early exercise of American options,
o
perform numerical computation of the Binomial
Models.
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