Options Pricing: Cox-Rubenstein Binomial Option Pricing Model
The Cox-Rubenstein (or Cox-Ross-Rubenstein) binomial option pricing model is a variation of the original Black-Scholes option pricing model. It was first proposed in 1979 by financial economists/engineers John Carrington Cox, Stephen Ross and Mark Edward Rubenstein. The model is popular because it considers the underlying instrument over a period of time, instead of just at one point in time, by using a lattice based model.
A lattice model takes into account expected changes in various parameters over an option's life, thereby producing a more accurate estimate of option prices than created by models that consider only one point in time. Because of this, the Cox-Ross-Rubenstein model is especially useful for analyzing American style options, which can be exercised at any time up to expiration (European style options can only be exercised upon expiration).
The Cox-Ross-Rubenstein model uses a risk-neutral valuation method. Its underlying principal purports that when determining option prices, it can be assumed that the world is risk neutral and that all individuals (and investors) are indifferent to risk. In a risk neutral environment, expected returns are equal to the risk-free rate of interest.
The Cox-Ross-Rubenstein model makes certain assumptions, including:
- No possibility of arbitrage; a perfectly efficient market
- At each time node, the underlying price can only take an up or a down move and never both simultaneously
The Cox-Ross-Rubenstein model is a two-state (or two-step) model in that it assumes the underlying price can only either increase (up) or decrease (down) with time until expiration. Valuation begins at each of the final nodes (at expiration) and iterations are performed backwards through the binomial tree up to the first node (date of valuation). In very basic terms, the model involves three steps:
- The creation of the binomial price tree
- Option value calculated at each final node
- Option value calculated at each preceding node
Figure 6: The Cox-Ross-Rubenstein model applied to an American-style options contract, using the Options Industry Council\'s online pricing calculator.
Catastrophe equity puts are used to ensure that insurance companies ...
Open trade equity (OTE) is the equity in an open futures contract.
An announcement by an investor who holds a security that he or ...
A company that owns or controls two or more banks. Mutlibank ...
A type of strategy regarding a put option, which is a contract ...
To maximize potential returns for certain levels of risk (while ...
Learn what a stock split is, how it is accounted for and where to find upcoming information about stock splits on the Internet.
Buy call options and maintain control over the price you pay and when to buy a given stock. Learn how to maintain control ...
Read about how investors can trade actual market indicators, such as the S&P 500 Index, rather than specific stocks or commodities.
Learn about the various methods a trader can use to minimize risk of loss or protect a portion of profits in an existing ...