Final answer:
The binomial option pricing model is a mathematical model that calculates the price of an option based on the assumptions that the price of the underlying asset follows a binomial distribution and that the options can only be exercised at expiration.
Its methodology involves constructing a binomial tree and calculating option prices at each node. The key inputs to the model are the current price of the underlying asset, exercise price, interest rate, time to expiration, and volatility.
Step-by-step explanation:
The binomial option pricing model is a mathematical model that calculates the price of an option based on the assumptions that the price of the underlying asset follows a binomial distribution and that the options can only be exercised at expiration.
It is used in finance to value options and determine fair prices.
The methodology of the binomial option pricing model involves constructing a binomial tree to simulate the possible price movements of the underlying asset over time.
At each node of the tree, the model calculates the option price by taking the present value of the expected payoffs at expiration.
The model then works backward through the tree to calculate the option prices at earlier time periods.
The key inputs to the model are the current price of the underlying asset, the exercise price of the option, the risk-free interest rate, the time to expiration, and the volatility of the underlying asset.
By inputting these values, the model can calculate the fair value of the option.