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Lecture 8 – Binomial Option Pricing Model
12 Pages • Partial Study Notes • Year: Pre-2018
Lecture 8 – Binomial Option Pricing Model Replicating Portfolio Valuation: • Derivative assets are, in fact, redundant. • Even if derivatives didn’t exist, we could artificially re-create them solely from the underlying assets. • Consider put call parity An Arbitrage-Free Value: • This ability to replicate the payoff to a derivative security using portfolios of the underlying asset and bonds is the key to arbitrage-free valuation. • The arbitrage free price of a derivative is enforced by the current prices of the stock and bond, and the existence of a replicating strategy. Replicating Portfolio Valuation of Call Option: • Major insight of BS (1973) was to show how to price a European call option using the replicating-portfolio methods. • A portfolio of stock and bond can replicate the option payoff. Hence, option price must equal the construction cost of the replicating portfolio. • BS developed the arbitrage-free price in a continuous-time framework. BINOMIAL OPTION PRICING: • Binomial model is a simple, yet extremely powerful
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