CHAPTER 5: NPERIOD Binomial Option Pricing Model
5.1
Overview

ne limitation of the oneperiod and twoperiod binomial
models is that the set of possible terminal stock values is quite small.
This limitation is overcome in a multiperiod model of stock price
movements. For example, suppose
there are five hours remaining in a trading day and one period equals one hour.
At the end of the day, the multiperiod binomial model would allow for 32
(25) possible endofday prices.
If a period equals one minute, we have 2300
possible ending values.
We extend the twoperiod binomial option pricing model to nperiods
in topic 5.2, Binomial Option Pricing: NPeriods. Appendix
C Chapter 5 Technical Topic: Limiting Results,
provides the formal derivation of this n period model, Binomial Option
Pricing: NPeriod Derivation.
The limiting behavior of this approach, as periods become
smaller and smaller, is discussed in topic 5.4, called Binomial Option Pricing: Limiting
Results. The nperiod
model converges in the limit to the BlackScholes option pricing model.
One advantage of the binomial approach is that not only does it
accommodate a wide range of option pricing problems, but also it provides an
interpretation of the BlackScholes pricing model.