Binomial tree

A lattice in which a price or rate moves to one of two values each period. Options, and bonds with embedded options, are valued on it by working backward from the final nodes.

Where you will meet it

Binomial tree appears in 2 learning outcomes on the CFA syllabus. A few of them:

• Explain replication and valuation under risk neutrality
  CFA Level I · Derivatives

  “The device generalises far beyond the binomial tree and underlies essentially all derivative pricing.”

• Explain how to apply the arbitrage-free approach when valuing a bond that contains embedded options
  CFA Level II · Fixed Income

  “To value a bond with embedded options, use a binomial tree calibrated to the benchmark curve with an assumed volatility, and value backward from maturity.”

See also

Embedded option

Practise it

• Today's practice question One question, with every wrong option explained.
• Free Level I diagnostic test Twelve questions that show which topics to start with.
• Free finance calculators Check your arithmetic on the exam's core formulas.

All terms beginning with B · Glossary