
434 Derivatives and Risk Management
Under binomial option valuation, we use the backward-recursive method, starting from the end of the
tree and moving backwards.
Determine the intrinsic value of the option on its exercise date, which is at the end of year 2.
C
++
= Max [0, (99.674 – 99.75)] = 0
C
+ –
= Max [0, (100.599 – 99.75)] = 0.849
C
––
= Max [0, (101.369 – 99.75)] = 1.619
In the binomial model for interest rate options, the risk-neutral probability is 0.5. Further, the
option value must now be discounted at dierent interest rates depending on where the option is on the
tree.
0
f
1
= 4%
c = ?
1
f
1H
= 4.6251%
c
+
= ?
1
f
1H
= 3.7867% ...