Binomial Lattice Option Pricing Model & Convertible Bond Valuation Tool

Overview

The Binomial Lattice Valuation Methodology can be utilized to value Real Options. The Binomial Lattice valuation methodology allows for changing levels of volatility because the binomial model breaks down the time to option expiration into time intervals. At each time interval, the underlying asset value can either move up or down, based on its volatility.  Changing the possible up or down movement at each time interval creates a binomial lattice. A binomial lattice model can be customized to include the below mentioned input variables, plus multiple risk-free rates changing over time, multiple volatilities changing over time, multiple dividend rates changing over time, plus all other real-life factors. It is important to note that valuation results through the use of binomial lattices tend to approach those derived from the closed model solutions; hence one should always utilize the Black-Scholes Option Pricing Model (BSOPM) model to benchmark the binomial lattice results. The results from the closed model solutions are typically used in conjunction with the binomial lattice approach when presenting a complete Employee Stock Option (ESO) valuation solution.   The assumptions include consideration of many factors that influence the fair market value of stock options including, but not limited to the following:

• The stock price;
• The strike prices;
• The time to maturity;
• The risk-free rate;
• The dividend; and
• Volatility.

The Binomial Lattice approach will also address the following items:

• Changing risk-free rates;
• Changing dividends; and
• Changing volatilities over time.

Sample Model Results:

Model Assumptions

Binomial & Trinomial

Valuation Calculation

Implied Trinomial Tree