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   Binomial Model
   















 

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Binomial Model

Binomial Model Lattice
A model of the form suggested by Cox, Ross, and Rubinstein and Sharpe which is based on the tendency of a binomial distribution to approach normality as a limit. The structure of the model is a branch network in which the underlying price or rate can rise or fall by a limited amount at each node. The weighted present values of the terminal node values are summed to determine option value. Alternatively, the option value can be derived by backward induction. The binomial model is useful when the underlying distribution is normal or lognormal yet adjustments for cash flows and early exercise are necessary, and when option payoffs are path dependent. Efforts to use a binomial model to approximate results of non-normal distributions should be viewed with suspicion. By the central limit theorem, a binomial distribution will converge to the normal distribution despite efforts to delay convergence by varying up and down probabilities. See also Backward Induction, Central Limit Theorem, Implied Binomial Tree, Lattice.

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