You can apply the binomial model to value non - standard options. This option may be attractive to firms that wish to hedge a stream of transactions over time. This is because the average price risk becomes a more relevant factor than the price at one time.

Defining the underlying asset in this way greatly complicates the option valuation problem. Now, its value depends upon the path followed by the underlying asset, and thus it is a path-dependent option.

Note that the problem is not to determine the option value at the end of its life, but rather at the beginning, when we do not know which path the stock price will take. The beauty of the binomial approach is that the same principles i. The difference is that the tree diagram becomes more complex.

Forward Interest Rates

Consider the tree in Figure 3. Binomial Tree for Stock Prices. To value an Asian option we first calculate the average stock price at every node.

To simplify this calculation we make the assumption that the average price is calculated only after the first tick is realized i.

The tree in Figure 3. We preserve the first part of the tree, and replace the terminal nodes with averages.

Option (finance) - Wikipedia

Binomial Tree for Average Stock Prices. The risk-neutral probabilities remain the same i.

You can now apply the risk-neutral valuation principle as before. You can verify that the value of the call option is obtained as shown in Figure 3. The put option can be valued in the same way.

Black Scholes Option Calculator

The tree diagram for the put option is as shown in Figure 3. Next, Chapter 4 introduces you to the use of options for controlling risk by applying the principle of dynamic hedging.

An overview of this chapter is provided next in Dynamic Hedging Strategies. Home Overview European Option: No Div American Put: No Div American Opt: American vrs Eur Ex: