This is illustrated by the following diagram. Price Tree for Underlying AssetĬonsider a stock (with an initial price of S 0) undergoing a random walk. Over a time step Δt, the stock has a probability p of rising by a factor u, and a probability 1-p of falling in price by a factor d. No-arbitrage means that markets are efficient, and investments earn the risk-free rate of return.īinomial trees are often used to price American put options, for which (unlike European put options) there is no close-form analytical solution. Rather than relying on the solution to stochastic differential equations (which is often complex to implement), binomial option pricing is relatively simple to implement in Excel and is easily understood. Scroll down to the bottom of this article to download the spreadsheets, but read the tutorial if you want to lean the principles behind binomial option pricing.īinomial option pricing is based on a no-arbitrage assumption, and is a mathematically simple but surprisingly powerful method to price options. Additionally, a spreadsheet that prices Vanilla and Exotic options with a binomial tree is provided. This tutorial introduces binomial option pricing, and offers an Excel spreadsheet to help you better understand the principles.
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