Valuing an American Option Using Binomial Tree-Derivative Pricing in Excel

Follow us on LinkedIn

In a previous post, we provided an example of pricing American options using an analytical approximation. Such a pricing model is fast and accurate enough for risk management purposes. However, sometimes more accurate results are required. For this purpose, the binomial (lattice) model can be used. Wikipedia describes the binomial tree model as follows,

In finance, the binomial options pricing model (BOPM) provides a generalizable numerical method for the valuation of options. The binomial model was first proposed by Cox, Ross and Rubinstein in 1979. Essentially, the model uses a “discrete-time” (lattice based) model of the varying price over time of the underlying financial instrument…

The binomial pricing model traces the evolution of the option’s key underlying variables in discrete-time. This is done by means of a binomial lattice (tree), for a number of time steps between the valuation and expiration dates. Each node in the lattice represents a possible price of the underlying at a given point in time.

Valuation is performed iteratively, starting at each of the final nodes (those that may be reached at the time of expiration), and then working backwards through the tree towards the first node (valuation date). The value computed at each stage is the value of the option at that point in time.

Derivative Pricing in Excel Binomial Tree Lattice

We utilized the lattice model previously to price convertible bonds. In this post, we’re going to use it to value an American equity option. We use the same input parameters as in the previous example. Using our Excel workbook, we obtain a price of $3.30, which is smaller than the price determined by the analytical approximation (Barone-Andesi-Whaley) approach.

Derivative Pricing in Excel Binomial Tree Workbook

American option valuation in Excel using Binomial Tree

Related post: Valuation of European and American Options-Derivative Pricing in Python

Further questions

What's your question? Ask it in the discussion forum

Have an answer to the questions below? Post it here or in the forum

LATEST NEWSCongress Passes $460 Billion Funding Deal, Avoiding Shutdown
Congress Passes $460 Billion Funding Deal, Avoiding Shutdown

The US Senate approved a $460 billion funding package, sending it to President Joe Biden in time to sign before a looming Saturday partial government shutdown.

Stay up-to-date with the latest news - click here
LATEST NEWSMicrosoft says it hasn’t been able to shake Russian state hackers
Microsoft says it hasn’t been able to shake Russian state hackers

BOSTON (AP) — Microsoft said Friday it’s still trying to evict the elite Russian government hackers who broke into the email accounts of senior company executives in November and who it said have been trying to breach customer networks with stolen access data. The hackers…

Stay up-to-date with the latest news - click here
LATEST NEWSUS providers could see credit impact from Change Healthcare hack, Moody's says
US providers could see credit impact from Change Healthcare hack, Moody's says
Stay up-to-date with the latest news - click here
LATEST NEWSPetrobras shares plunge on axed dividend as Brazil pushes more investment
Petrobras shares plunge on axed dividend as Brazil pushes more investment
Stay up-to-date with the latest news - click here
LATEST NEWSUS Senate passes spending bill, averts imminent shutdown
US Senate passes spending bill, averts imminent shutdown
Stay up-to-date with the latest news - click here

Leave a Reply