CFA Level 1 | Derivatives: Binomial Option Pricing Model

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CFA Level 1
Topic: Derivatives
Reading: Basics of Derivative Pricing and Valuation

In the binomial option pricing model, the no-arbitrage price of the option is the weighted option payoff discounted at the risk-free rate. The weight used is the risk neutral probability, based on (1 + r - d)/(u - d).

1) If option price is equals to the no-arbitrage price, there will be no arbitrage opportunities.

2) If option price is greater than the no-arbitrage price (option overpriced), there will be arbitrage opportunities (i.e. positive excess return).

3) If option price is less than the no-arbitrage price (option underpriced), there will be arbitrage opportunities (i.e. positive excess return).

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