These classes are all based on the book Trading and Pricing Financial Derivatives, available on Amazon at this link. https://amzn.to/2WIoAL0
Check out our website http://www.onfinance.org/
Follow Patrick on twitter here: https://twitter.com/PatrickEBoyle
This is the fifth video in our series on pricing options. The whole series is collected as a playlist here: https://www.youtube.com/watch?v=LHaftRA2N8A&list=PLHC72UlhAthDq-s_jRepKDrsaeGDU3PaJ
If you are new to options pricing and binomial trees it might make sense to watch some of the other videos first.
Binomial Trees and American Options
American options can be exercised anytime up to maturity, as opposed to European options which can only be exercised at maturity. Binomial trees can be used to price American options with the only modification needed is to evaluate at each node as to whether there is more value associated with exercising or holding the option to expiration. The highest of these two values is used in calculating the option value.
In the two-step American binomial tree valuation shown in this video, we are using the same example as in our last video but with the option now American. In this case, at T1 it would be optimal to early-exercise. Thus the valuation at the first down node is in fact the early-exercise valuation, which is the intrinsic value at that node, as opposed to the valuation achieved from the risk-neutral valuation for fd. At time zero, the valuation of the derivative is based on fu as usual, but the fd value input into the formula for f is the early exercise cash flow.
To watch the video where we priced the same put option, but as a European option, click here. https://www.youtube.com/watch?v=nN4tOYVqf9o
Pricing American Options using the Binomial Tree Method
multi step binomial trees
