Introduction to the Binomial Option Pricing Mode
The subject of option pricing theory is daunting to most students because it is one of the most difficult areas of finance. Professors Stuart Gilson and Nabil El-Hage developed an online tutorial, Introduction to the Binomial Option Pricing Model, to help finance students understand essential concepts in option valuation.
In the first-year MBA required course, Finance 2, students learn about several option pricing models, including the Binomial Model and the Black-Scholes-Merton. This tutorial was developed to explain the Binomial Model in detail, so that students master the fundamentals of option valuation before proceeding to more advanced topics. Students complete the tutorial as homework so that they are prepared in class the next day for a more advanced discussion of option pricing theory.
"Rather than spending valuable class time going through the mechanics of valuing stock options using the Binomial Model (which can take 40 minutes or more), we can now assume students have done this outside of class time using the tutorial. We spend the time in class far more productively to ask: What does this all mean? How do we use it? How applicable to real-life situations is it? So, the tutorial is a building block for more advanced options valuation techniques."
-- Professor Nabil El-Hage
The tutorial refers to a case that has been used for many years to teach option valuation, "Sally Jameson: Valuing Stock Options in a Compensation Package," in which Sally, the case protagonist, has to determine the value of stock options being offered to her by a prospective employer. The tutorial shows how Sally can create a replicating portfolio, comprised of stocks and bonds, that mimics the payoffs of the stock options. Using that portfolio, she can calculate the current value of the stock options that have been offered to her as part of her compensation package.
To improve student comprehension of a difficult topic, the tutorial uses animations that demonstrate each step in the Binomial Option Pricing Model so that the students understand all aspects of the model. Interactive exercises are used to test student comprehension, and an option calculator allows students to see how features of an option, its underlying asset, and the market as a whole affect an option's value.
