Binomial model
Principles of Finance glossary · Time Value of Money
Definition
A discrete-time option pricing model in which the underlying price can move up or down by fixed multiplicative factors each period.
Binomial model in plain English
An option is a contract whose payoff depends on where some price (say a stock) ends up, so to value it you need to imagine how that price might travel over time. The binomial model keeps this dead simple: in each time step the price can only do one of two things — tick up by a set factor or down by a set factor — like a coin flip. String many of these flips together and you get a branching tree of every path the price could take, and by working backwards from the payoffs at the end you can figure out what the option is worth today. It's the training-wheels version of option pricing — crude per step, but shockingly accurate once you chop time into many small steps.
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