DECEMBER No. 5 Two-State Option Pricing RICHARD J. RENDLEMAN, JR. and BRIT J. BARTTER" I. Introduction IN THIS PAPER WE present an elemental two-state option pricing model (TSOPM) which is mathematically simple, yet can be used to solve many complex option pricing problems. 1 In contrast to widely accepted option pricing models which require solutions to stochastic differential equations, our model is derived algebraically. First we present the mathematics of the model and illustrate its application to the simplest type of option pricing problem. Next, we discuss the statistical properties of the model and show how the parameters of the model can be estimated to solve practical option pricing problems. Finally, we apply the model to the pricing of European and American put and call options on both non-dividend and dividend paying stocks. Elsewhere, we have applied the model to the valuation of the debt and equity of a firm with coupon paying debt in its capital structure , the valuation of options on debt securities , and the pricing of fixed rate bank loan commitments [1, 2]. In the Appendix we derive the Black-Scholes  model using the two-state approach. II. The Two-State Option Pricing Model Consider
The Journal of Finance – Wiley
Published: Dec 1, 1979
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