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Unformatted text preview: ard through the tree, determining values as in the previous section. Let us take the two period example above, where there are three possible stock prices at time 2: , and . The option price changes from to either or at time 1. Each of these prices is the value of a one period option expiring one period later, at time 2. At time 2 we know the payoffs of the option. ✟ ✟ ❍❍ ✟ ✟✟ ❍❍ ❍ ✟ ✟ ✯ ✟ ❍❍ ✟✟ ❍❍ ✟ ❥ ❍✟ ❍❍ ✯ ✟ ✟ ✟✟ ✟✟ ❍❍ ❍ ❍❍ ❥ ❍ ✯ ✟ ✟✟ ✟ ✟✟ ❍❍ ❍❍ ❍ ❥ ❍ To price we “work backwards.” We start with the two possible call values at time 1. These can be calculated using the one period method we used in the previous chapter. Then, given the two possible values at time 1, we are again working with a one period problem, a derivative with two possible payoffs and at time 1. ✟ ✟✟ ❍ ❍❍ ✟ ✟✟ ❍ ❍❍ ✯ ✟ ✟ ❍ ❥ ❍ This is again solved using the state price probabilities calculated before. 136 Multiple Periods in the Binomial Option Pricing M...
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This document was uploaded on 02/15/2014 for the course BEM 103 at Caltech.

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