Two‐State Option Pricing

Two‐State Option Pricing 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 [9], the valuation of options on debt securities [7], and the pricing of fixed rate bank loan commitments [1, 2]. In the Appendix we derive the Black-Scholes [3] model using the two-state approach. II. The Two-State Option Pricing Model Consider http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Journal of Finance Wiley

Two‐State Option Pricing

The Journal of Finance, Volume 34 (5) – Dec 1, 1979
18 pages

/lp/wiley/two-state-option-pricing-aXYooy90YV
Publisher
Wiley
1979 The American Finance Association
ISSN
0022-1082
eISSN
1540-6261
D.O.I.
10.1111/j.1540-6261.1979.tb00058.x
Publisher site
See Article on Publisher Site

Abstract

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 [9], the valuation of options on debt securities [7], and the pricing of fixed rate bank loan commitments [1, 2]. In the Appendix we derive the Black-Scholes [3] model using the two-state approach. II. The Two-State Option Pricing Model Consider

Journal

The Journal of FinanceWiley

Published: Dec 1, 1979

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