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CHAPTER 5:  N-PERIOD Binomial Option Pricing Model

5.1  Overview


ne limitation of the one-period and two-period binomial models is that the set of possible terminal stock values is quite small.  This limitation is overcome in a multi-period 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 multi-period binomial model would allow for 32 (25) possible end-of-day prices.  If a period equals one minute, we have 2300 possible ending values.

We extend the two-period binomial option pricing model to n-periods in topic 5.2, Binomial Option Pricing: N-Periods.  Appendix C Chapter 5 Technical Topic: Limiting Results, provides the formal derivation of this n- period model, Binomial Option Pricing:  N-Period 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 n-period model converges in the limit to the Black-Scholes 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 Black-Scholes pricing model.