Binomial Tree

AAA

DEFINITION of 'Binomial Tree'

A graphical representation of possible intrinsic values that an option may take at different nodes or time periods. The value of the option depends on the underlying stock or bond, and the value of the option at any node depends on the probability that the price of the underlying asset will either decrease or increase at any given node.

INVESTOPEDIA EXPLAINS 'Binomial Tree'

Binomial trees are useful tools when pricing options and embedded options, but there is a fundamental flaw with the model. The problem lies in the possible values the underlying asset can take in one period time. In this model, the underlying asset can only be worth exactly one of two possible values, which is not realistic, as assets can be worth any number of values within any given range.

RELATED TERMS
  1. Algebraic Method

    A mathematical means of solving a pair of linear equations. Algebraic ...
  2. Functional Decomposition

    A method of business analysis that dissects a complex business ...
  3. Decision Tree

    A schematic tree-shaped diagram used to determine a course of ...
  4. European Option

    An option that can only be exercised at the end of its life, ...
  5. Embedded Option

    A provision in a security that is an inseparable part of the ...
  6. Binomial Option Pricing Model

    An options valuation method developed by Cox, et al, in 1979. ...
Related Articles
  1. Options & Futures

    Breaking Down The Binomial Model To Value An Option

    Find out how to carve your way into this valuation model niche.
  2. Fundamental Analysis

    Find The Right Fit With Probability Distributions

    Discover a few of the most popular probability distributions and how to calculate them.
  3. Options & Futures

    The "True" Cost Of Stock Options

    Perhaps the real cost of employee stock options is already accounted for in the expense of buyback programs.
  4. Entrepreneurship

    Getting To Know Business Models

    Learning how to assess business models helps investors identify companies that are the best investments.
  5. Options & Futures

    Trade Covered Calls On High Dividend Paying Stocks

    We explain the risks, rewards, timing, and profit and loss considerations for covered calls with dividend stocks.
  6. Options & Futures

    Was Buffet Right about Derivatives as WMDs?

    Why Warren Buffet described derivatives as weapons of mass destruction, and when can they be helpful or harmful?
  7. Economics

    Understanding Perpetuity

    Perpetuity means without end. In finance, a perpetuity is a flow of money that will be received on a regular basis without a specified ending date.
  8. Bonds & Fixed Income

    Should Junk Bond ETFs Be a Part of Your Portfolio?

    Should junk bonds be a part of your portfolio? Here's what you need to know.
  9. Fundamental Analysis

    What is a Null Hypothesis?

    In statistics, a null hypothesis is assumed true until proven otherwise.
  10. Professionals

    Vanguard Readies Muni Bond ETF

    Vanguard is set to roll out a muni bond ETF, the firm's first.

You May Also Like

Hot Definitions
  1. Interest Rate Risk

    The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between ...
  2. Income Effect

    In the context of economic theory, the income effect is the change in an individual's or economy's income and how that change ...
  3. Price-To-Sales Ratio - PSR

    A valuation ratio that compares a company’s stock price to its revenues. The price-to-sales ratio is an indicator of the ...
  4. Hurdle Rate

    The minimum rate of return on a project or investment required by a manager or investor. In order to compensate for risk, ...
  5. Market Value

    The price an asset would fetch in the marketplace. Market value is also commonly used to refer to the market capitalization ...
  6. Preference Shares

    Company stock with dividends that are paid to shareholders before common stock dividends are paid out. In the event of a ...
Trading Center