QUESTION 1: Explain the Binomial Pricing Model for the calculation of Option Premium - both

single and multi-period model

A: Imagine we want to know how much a "special coupon" is worth, and this coupon depends on the
price of a certain product (let's say a phone). The phone's price can go up or down over time.

1. Single-Period Model (2 time steps):

● Today, the phone costs Rs. 100/-

● In the next period, it can either go up in price to Rs. 120/- or down to Rs. 80/-

● We have this "special coupon" that gives us some money if we decide to use it when
the phone's price changes.

● The coupon's value at the end of the period will be the difference between the
phone's price and a certain fixed price (let's say Rs. 105/-), but only if it's positive (if
the phone price is higher than Rs. 105/-).

● If the phone price ends up below Rs. 105/- , the coupon is worthless (its value is
zero).

Now, you want to know how much the "special coupon" is worth today, given the possibilities of the
phone's price going up or down. To do this, you calculate the expected value of the coupon by
considering the probabilities of the phone's price going up or down. And then discount the same to
the present (find Present value of expected value after the period).

Therefore, the single period binomial option pricing model is the simplest version of the binomial
model, involving only two time steps. It assumes that the underlying asset's price can only move up
or down in one period.

2. Multi-Period Model (more than 2 time steps):

● Now, we look at the phone's price over several periods (for example, 3 periods).

● At each period, the phone's price can go up or down by a certain percentage (let's
say 20%).

● Just like before, we have the "special coupon" that depends on the phone's price at
each period.

To know the value of the "special coupon" today, we work backward from the last period to the
present. We calculate the expected value of the coupon at each period and then move back in time,
taking into account the probabilities of the phone's price going up or down at each step.

So, the multi-period binomial model extends the single-period model to multiple time steps,
allowing for a more realistic representation of the underlying asset's price movement.

Therefore, to summarize, to calculate the option's value, we work backward from the expiration
time step to the present, calculating the option's value at each intermediate time step using the risk-
neutral probability approach.
The multi-period binomial model becomes computationally intensive as the number of time steps
increases, but it provides a more accurate valuation of options as it considers a wider range of
possible price movements.

In both cases, the Binomial Pricing Model helps us figure out the fair value of the "special coupon"
(option) today, based on the possible future prices of the phone. It's a useful tool in finance for
understanding how options are priced when the underlying asset's price can change over time.

Here, the “special coupon” refers to the option. We are trying to calculate its “current value”, that is,
the price at which it would be bought or sold today. This “price of the option” is known as
“premium”, or it’s current value. Premium refers to the money given by the buyer of the option to
the seller of the option. This amount is given as a price for the right which the buyer of the option
now holds to exercise the option as per the market price at a future date. Since the seller of the
option is the one that risk of market volatility is being transferred to, the seller charges the
“premium”.

In more technical terms, the Binomial Pricing Model is a popular mathematical method used to
calculate the theoretical fair value of options, such as call and put options, based on certain
assumptions about the underlying asset's price movement. The model assumes that the asset's price
can follow a binomial distribution over a series of discrete time steps. It is widely used in finance to
value derivatives, especially in cases where the Black-Scholes option pricing model is not directly
applicable.

The cases are mentioned below with short details:

● American Options: The Black-Scholes model assumes that options can only be exercised at
expiration, which is true for European options. However, American options can be exercised
at any time before or on the expiration date. Since the timing of exercise affects the option's
value, the Black-Scholes model's assumptions are not appropriate for American options.
● Exotic Options: Exotic options are a class of financial derivatives that have unique or non-
standard features compared to standard options, such as European and American options,
making them more complex and not conforming to the basic assumptions of the Black-
Scholes model.
● Options on Assets with Dividends: The Black-Scholes model assumes that the underlying
asset does not pay dividends during the option's lifespan. For options on assets that do pay
dividends, the model's assumptions are not valid, and adjustments need to be made to
account for the dividends.

Here's how the Binomial Pricing Model works:

1. Assumptions:

● The underlying asset's price can only move up or down by certain factors (u and d)
over each discrete time step.

● The risk-free interest rate (r) is constant and known.

● The time to expiration (T) is divided into N discrete time steps.

2. Building the Binomial Tree:

 ● Create a binomial tree representing the possible price movements of the underlying
asset over time.

● Starting at the Current Market Price (CMP), calculate the potential asset prices at
each subsequent time step, both upward and downward, based on the up and down
movement factors.

3. Calculating Up and Down Movement Factors (u and d):

● The up movement factor (u) represents the factor by which the asset's price will
increase over one time step.

● The down movement factor (d) represents the factor by which the asset's price will
decrease over one time step.

● Typically, u and d are calculated based on the asset's volatility and the time step.

4. Calculating Option Payoffs at Expiration:

● For each possible asset price at the expiration of the option, calculate the option's
payoff.

● For an option contract, the payoff at expiration is to the extent of which the option is
in-the-money.

5. Considering the money-ness of the option

● For a call option, if the possible price at the time of expiry (upside and downside
calculated), is more than the strike price, it will be considered an “in-the-money”
option. On the other hand, if the possible price at the time of expiry (upside or the
downside), is less than the strike price, it will be considered an “out-of-the-money”
option.
● In the case of a put option, it’s vice versa. If the possible future price is less than the
strike price, it’s an in-the money option. If the possible future price is more than the
strike price, it’s an out of the money option.
● But what does an “in-the-money” option mean? An "in the money" option is an
options contract that currently has intrinsic value. It refers to the situation where
the option's strike price and the current market price of the underlying asset are
such that the option can be profitably exercised if it were to expire immediately. In
other words, the strike price is better than the current market price.
● On the other hand, an "out of the money" option is an options contract that
currently does not have any intrinsic value. It refers to the situation where the
option's strike price and the current market price of the underlying asset are such
that exercising the option would not result in a profitable outcome if it were to
expire immediately.
 ● Out of the money options typically have lower premiums (prices) compared to "in
the money" or "at the money" options because their current lack of intrinsic value
makes them less attractive to market participants. The value of out of the money
options is primarily determined by their time value, which represents the possibility
of the option becoming profitable before its expiration date due to changes in the
underlying asset's price.

6. Calculating the probability

● In the Binomial Option Pricing Method, we calculate probabilities to employ a risk-

neutral approach (The risk-neutral approach in derivatives is a simplifying
assumption where derivatives are priced as if investors are risk-neutral, making the
expected return on all assets equal to the risk-free rate.), allowing us to replicate the
market price of the option and derive its fair value. These probabilities are essential
because they play a crucial role in determining the expected option value at each
time step in the binomial tree.
● Probability is calculated using the risk free return rate and the upside and downside
possibility.

7. Calculating Option Values Backwards:

● Starting from the last time step (expiration), calculate the option's value at each
preceding time step by discounting the future expected payoffs back to the present
using the risk-free interest rate.

● At each time step, the option value is the discounted expected value of the option in
the next period.

8. Final Result:

● The value of the option at the initial time step (present) represents its theoretical
fair value in the market.

By using the Binomial Pricing Model, investors and financial analysts can estimate the fair value of
options, which is useful for making informed decisions about trading and investment strategies.

When we assume the continuous changes in the prices over a period of time, it becomes difficult to
handle the pricing through binomial and that is where black scholes come in. It converts the complex
approach into a simple formula.

To understand the working of the binomial Pricing Model for the calculation of Option Premium -
both single and multi-period model better,

Please find the following numericals attached at the end of the word document:

1. Multi Period Call Option

2. Multi Period Put Option

3. Single Period Call Option

4. Single Period Put Option

QUESTION 2: Advantages and disadvantages of Option Premium Pricing Model

A: Advantages:

Fair Valuation: Option premium pricing models provide a fair valuation of options, helping investors
assess whether an option is overpriced or underpriced in the market.

Risk Management: By knowing the theoretical value of options, investors can better manage their
risk exposure and make informed decisions about hedging strategies.

Arbitrage Opportunities: Pricing models help identify arbitrage opportunities, where traders can
profit from price discrepancies between options and their underlying assets.

Market Insights: Option pricing models provide insights into implied volatility, reflecting market
expectations and sentiment.

Flexibility: Some models (e.g., binomial model) can handle a wide range of option types, making
them adaptable to various market conditions.

Disadvantages:

Simplifying Assumptions: Models are based on assumptions that may not perfectly match real-world
market conditions, potentially leading to inaccuracies.

Complexity: Some models (e.g., Black-Scholes) have complex mathematical formulas, requiring
advanced knowledge and computations.

Data Requirements: Models may demand accurate and up-to-date data for underlying assets,
interest rates, and volatility estimates.

Limited Applicability: Certain models are not suitable for exotic options or options on assets with
dividends.

Market Liquidity: Pricing models assume liquid markets, but in illiquid markets, the theoretical price
may differ from actual market prices.

Dynamic Nature: Option prices change continuously with market movements, making it challenging
to keep up-to-date valuations.
No Guarantee of Accuracy: Even with sophisticated models, actual option prices can deviate from
theoretical values due to various market factors and uncertainties.

Over reliance on Models: Relying solely on models may lead to overlooking other crucial factors
influencing option prices.

Overall, option premium pricing methods offer valuable insights and tools for understanding and
valuing options. However, users should be aware of the limitations and carefully interpret the results
in conjunction with other relevant market information.

QUESTION 3: Usage of Option Premium Pricing Model

A: There are mainly 2 types of option premium pricing models. The Black-Scholes model and the
Binomial Model. We’ll look at both of them in detail, separately.

The Black-Scholes option pricing model is a mathematical formula developed by Fischer Black,
Myron Scholes, and Robert Merton in the early 1970s. It is used to estimate the theoretical fair value
of European-style call and put options. The model assumes that the underlying asset's price follows a
geometric Brownian motion, meaning that its price changes continuously over time. It refers to the
random and unpredictable nature of the underlying asset's price movement.

The usage of the Black-Scholes method for Option Premium Pricing are as follows:

1. Option Valuation: The primary purpose of the Black-Scholes model is to value European-
style options. Traders, investors, and financial institutions use it to determine the theoretical
fair value (premium-cost of the option) of call and put options.

2. Option Trading: Traders use the Black-Scholes model to assess the relative attractiveness of
different options and make informed trading decisions. If the calculated option price is
significantly different from the market price, it may indicate potential arbitrage
opportunities.

3. Risk Management: The model is used in risk management to assess the exposure to option
positions and quantify potential losses in the options portfolio under different market
scenarios.

4. Investment Strategies: Portfolio managers use the Black-Scholes model to analyse the
impact of adding options to their portfolios and to develop strategies for enhancing returns
or hedging risks.

5. Option Pricing Sensitivity Analysis: The model allows analysts to conduct sensitivity analysis
by varying input parameters (e.g., underlying price, volatility, interest rate) to observe their
impact on the option's price

The Binomial option pricing model is a mathematical approach used to estimate the theoretical fair
value of options, including both European and American-style options. It is based on the concept of
discrete price movements in the underlying asset over time, unlike the continuous price movements
assumed in the Black-Scholes model. "Discrete price movement" refers to a situation where the
price of an asset can only change by specific and predetermined increments over time, rather than
changing continuously. In other words, the asset's price can only move by certain fixed amounts,
either up or down, during each time step.

The usage of the Binomial Method for Option Premium Pricing are as follows:

1. Valuing Options: The primary purpose of the Binomial model is to value both European and
American-style options. This enables investors and traders to determine the fair value of
options and make informed decisions about buying, selling, or holding them.

2. American Option Pricing: Unlike the Black-Scholes model, the Binomial model is capable of
valuing American-style options, which can be exercised at any time before expiration.

3. Risk Management: The model is used in risk management to assess the exposure to option
positions and quantify potential losses in the options portfolio under different market
scenarios.

4. Option Trading Strategies: Traders use the Binomial model to analyze and create option
trading strategies. By understanding the model's output, traders can make more informed
decisions about the potential profitability of their trades.

5. Education and Understanding: The Binomial model serves as a valuable educational tool,
helping students and professionals understand the concept of option pricing, risk-neutral
probability, and the impact of different factors on option values.

6. Real-World Applications: The Binomial model is widely used in finance and investment
management for option valuation in real-world scenarios, such as valuing employee stock
options and designing complex derivatives.

In summary, the Binomial option pricing model is a versatile and widely used method for valuing
options in finance. Its ability to handle both European and American-style options, along with
discrete price movements, makes it a valuable tool for option traders, portfolio managers, risk
analysts, and other financial professionals.

In summary, The Black-Scholes model is widely used for valuing European-style options in liquid and
continuous markets, especially when computational efficiency and closed-form solutions are crucial.
It finds common applications in options trading, risk management, and valuing employee stock
options. However, it is less suitable for valuing American-style options and assets with discrete
events. On the other hand, the Binomial model is applied to value both European and American-
style options, accommodating early exercise decisions. It is particularly useful when asset price
movements are discrete or when dividends need consideration. The Binomial model's versatility
makes it suitable for complex derivatives and scenarios where closed-form solutions are not readily
available, offering more flexibility in handling a broader range of option types and underlying asset
situations.

The binomial model and Black-Scholes model are both used to value options, with the binomial
model being discreet and the Black-Scholes model being continuous. The convergence of these
methods occurs as the number of steps in the binomial model increases towards infinity, making its
valuations approach those of the Black-Scholes model. For practical purposes, a relatively small
number of steps in the binomial model is often sufficient to achieve a reasonable level of
convergence. However, the binomial model offers more flexibility in certain situations, such as
options with early exercise features or discrete dividends.

In conclusion, The pricing of European and American options differs primarily due to the exercise
rules. European options can only be exercised at expiration, resulting in slightly lower premiums
than equivalent American options, which can be exercised at any time before or on the expiration
date. The added flexibility of early exercise makes American options more valuable, leading to higher
premiums compared to European options with the same underlying asset, strike price, and
expiration date.

QUESTION 4: Numerical example of Option Pricing Model - Explain both American and European
model.

A: The numerical example of the American Option Pricing model have been already done while
answering the first question. Please find numerical example of European Option attached at the end
of this word document.

To cover the concept of binomial option pricing model in all possible ways, a total of 6 types of
sums have been calculated and submitted in the below mentioned order. They are as follows:

1. American single period call option

2. American single period put option

3. American multi period call option

4. American multi period put option

5. European multi period call option

6. European multi period put option