ABSTRACT
This chapter describes the simplest model-based, yet still rational option pricing model. This model is called the Binomial Option Pricing Model (BOPM) and it is a discrete time model. The BOPM uses a decision tree framework but goes beyond it. Most of the central option valuation concepts, including discounting option payoffs, can be understood in the context of the BOPM. One of the main ideas that comes out of this model is the notion of static vs. dynamic hedging. This is a rarely stressed feature of the BOPM but if one wants to understand continuous-time option pricing models like Black-Scholes. Rational option pricing models make no restrictions on the process generating underlying spot prices, other than that they are arbitrage-free. Model-based option pricing models place restrictions on the process generating underlying spot prices. The thing to note is that model-based option pricing models must also be arbitrage-free.
