Constructing Binomial Tree to Describe Stock Price Movement
The future price movement of a stock can be approximated using a binomial tree. In a binomial tree, a stock can
Let’s say the current stock price is S. The price of the stock can either move or move down. We will refer to the up movement as u and a down movement as d. A down movement d will then be given by d where d is assumed to be equal to 1/u. We also need the probability of an up move (p) and the probability of a down move (1 - p).
The following diagram shows the price movement in a small time period Δt.
From each node at Su and Sd, the prices can again take two possible paths.
- Su can move to Suu or Sud. Note that Sud will be the same as S (S*u*1/u).
- Sd can move to Sdu (or just S) or Sdd.
This way a binomial tree can be built for multiple periods. The following diagram shows the binomial tree for 4 periods.
Let’s take an example to understand these values.
Initial stock price, S = $20
u = 1.02
d = 1/1.02
Probability of up move, p = 0.60
Probability of down move, (1-p) = 0.40
The possible stock values for period 1:
Su = 20*1.02 = 20.40 with a probability of 0.60
Sd = 19.60 with a probability of 0.40
The possible stock values for period 2:
Suu = 20.81 with a probability of 0.60*0.60 = 0.36
S = $20 with a probability of 2*0.60*0.40 = 0.48
Sdd = 19.22 with a probability 0.40*0.40 = 0.16
Similarly we can calculate the values for period 3 and period 4. Binomial trees have their application in pricing options and other financial concepts.
The following diagram shows this binomial tree upto two periods.
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