9. Case Studies (Real-World Applications)
Case Study 1: Investor Pricing a Stock Option
Situation:
An investor wants to estimate the fair price of a call option.
Approach:
- Uses binomial model to simulate price movements
Insight:
Helps determine whether an option is overpriced or underpriced.
Case Study 2: Corporate Decision Making
Situation:
A company evaluates an investment opportunity with uncertain outcomes.
Approach:
- Uses binomial logic to model different scenarios
Insight:
Binomial trees are useful beyond finance—they support decision analysis.
Case Study 3: American Options Flexibility
Situation:
An option can be exercised early.
Approach:
- Binomial model allows checking value at each step
Insight:
Unlike some models, binomial trees handle early exercise decisions.
Case Study 4: Risk Management
Situation:
A trader wants to understand risk exposure.
Approach:
- Uses binomial tree to visualize price paths
Insight:
Provides a clear picture of possible outcomes and risks.
10. Advantages of Binomial Model
- Simple and intuitive
- Flexible (works for different option types)
- Handles American options
- Easy to visualize
11. Limitations
- Becomes complex with many steps
- Less efficient than advanced models for large calculations
12. Key Takeaways
- Binomial trees model price movement step by step
- Option pricing is done using backward induction
- Useful for understanding uncertainty and decision-making
- Foundation for more advanced models
13. Quick Practice
Scenario:
A stock price is 50. It can go up to 60 or down to 40. Strike price is 50.
Question:
- What is the call option payoff in each case?
- Which outcome creates value?