4. Binomial Trees: Introduction

4.5. Summary

In this chapter, we have studied real option valuation with binomial trees. We have seen that, in order to estimate  these option values, we need to know the following about the underlying asset and the option in question:

  • Current value of the underlying asset (S)
  • Future possible movements of the value of the underlying asset (our price factors u and d)
  • Future expected dividend payments
  • Price at which we can buy (in the case of a call option) or sell (put option) the underlying asset (X)
  • How long the right is valid (time to maturity)
  • Risk-free rate or return (R)

Once we have the relevant information about these six parameters, we can estimate option values with the binomial tree model.