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Key Financial Market Concepts, 2nd Edition by Bob Steiner

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Binomial Pricing Model

Definition

A binomial pricing model is a method of valuing an option based on building a lattice of all the possible paths up and down that the underlying price might take from start until expiry, assuming that, at each price change, the price either rises by a given amount (or proportion), or falls by a given amount (or proportion).

How is it used?

One way of building a model for option pricing is to simplify the assumptions to the possibility that the price of something may move up by a certain amount or down by a certain amount in a particular time period. Suppose, for example, that the price of a particular asset is now 1 and that, each month, the price may rise by a multiplicative factor of 1.010000 or fall by a ...

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