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CHAPTER 3:  BINOMIAL MODEL Two-Period Analysis

3.1  Overview


n the one-period binomial model, there are only two possible terminal stock values.    In this chapter, we extend the binomial model to two periods, where the stock value can move up or down in each period.  This means that there are two possible stock values at the end of the first period and four possible values at the end of the second period.

We derive the values of European options in  topic 3.2, Two-Period Binomial Model: European Option.  These options can be exercised only at maturity. We then introduce you to  American options, where you can exercise the options either in period 1 or in period 2.  American options bring a lot of richness to the option pricing problem, and we start having to consider puts and calls separately. Topic 3.3, American Call Option: Zero-Dividend Case examines the implications of the right to exercise in both periods on the call valuation problem.  Put options are studied in topic 3.4 American Put Option: Zero-Dividend Case.

Dividends also complicate the American option pricing problem. We introduce dividends in topic 3.5 Dividends and American Options and  apply the principles of the two-period model to valuing European and American options in the topic 3.6, Two-Period European versus American Option Example.  Finally, in topic 3.7, we apply the principles of the binomial option pricing model to a popular "exotic" option called the Asian Option.