BINOMIAL MODEL [Other Topics : Right Mouse Click]

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Graphical Representation of Option Price and Sensitivities

The binomial approach is a discrete valuation model for European/American options on derivative securities, it was first suggested by William Sharpe in 1978.
However, this methodology is normally associated with the paper by John Cox, Stephen Ross, and Mark Rubinstein in 1979.
The binomial approach also known as lattice approach can be used to value wide-range of general derivative securities and also to obtain exact formula by taking the limit in which the binomial tree converges to a continuum.
As proposed by Cox, Ross, Rubinstein, this method divides the time until option maturity into discrete intervals and presumes that,
during each of these intervals, the price of the asset - e.g., the stock - follows a binomial process moving from its initial value, S, to Su (with probability p) or Sd(with probability 1-p).
Given this set of share prices, the call/put can be valued by working backwards from maturity.

The power of the binomial model is that it can value wide-range of derivative securities.
For example, we can use the two binomial tree to price a Two-Assets option.

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