Two step binomial model

[Guest 61086]

In a two period binomial model, and assume that the option being valued is 6 months, with std deviation is 8 percent. For the initial up factor calculation the formula is Exp 0.08 srt .025. My question is why was time not calculated as .5, as this a 6 month call option? The up factor period selected is 3 months so does the calculation then mean that the first period will be half of the total time ie 6 months? Thanks

 

[Nicole Seaman]

In a two period binomial model, and assume that the option being valued is 6 months, with std deviation is 8 percent. For the initial up factor calculation the formula is Exp 0.08 srt .025. My question is why was time not calculated as .5, as this a 6 month call option? The up factor period selected is 3 months so does the calculation then mean that the first period will be half of the total time ie 6 months? Thanks

Hello @Tim_Rogers

Is this information coming from a specific practice question that you are working on? If so, it is helpful if you post the entire practice question and answer, as many times seeing the exact source is helpful when David or other members are trying to answer your question. It may also be helpful to you if you use the search and tag functions in the forum because you may be able to find your answer without having to wait for others, as binomial models have been discussed many times in the forum.

Nicole

 

[Detective]

In a two period binomial model

If it’s 2 periods, with t=6 months to maturity, then each period will be 6/2=3 months long. If it was 6 periods then each period would be 1 month.

Does this help?

If you want to think in terms of “t” as time to maturity, perhaps you can write formula as:

u=exp(sigma*sqrt(t/n))

Where n=number of periods

 

[Guest 61086]

Yes, this does help, thanks. I expected it to be the case, but I assumed that from a 6 month period that the first step was being arbitrarily selected to be one half of the total period ie 3 months. Thanks and appreciate the response.