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How do I adjust the BSM Model to price binary options?
Posted: January 12th, 2018, 2:04 pm
by 60202
Hello,
I'm trying to figure out a way to price binary options where the payoff is either 0 or a fixed value. I did some quick Googling and seems like people do use the BSM model to price binary options but I'm not seeing any instructions on how to adapt it.
Any suggestions?
Thanks!
Re: How do I adjust the BSM Model to price binary options?
Posted: January 12th, 2018, 2:17 pm
by Paul
Re: How do I adjust the BSM Model to price binary options?
Posted: January 12th, 2018, 2:35 pm
by 60202
oh wow, didn't know this site has a wiki. Thakns!
so there's no need for the d1 term at all for pricing binary options?
Re: How do I adjust the BSM Model to price binary options?
Posted: January 12th, 2018, 3:08 pm
by bearish
oh wow, didn't know this site has a wiki. Thakns!
so there's no need for the d1 term at all for pricing binary options?
It depends on the option. If the option specifies that you receive the underlying asset if its value is above (or, alternatively, below) the strike price, then you need d1 but not d2.
Re: How do I adjust the BSM Model to price binary options?
Posted: January 12th, 2018, 3:15 pm
by 60202
thank you. the one i'm trying to price is cash settled.
Re: How do I adjust the BSM Model to price binary options?
Posted: February 13th, 2018, 12:54 am
by EdwinB
Although it seems easy The Feynman-Kac formula says that the solution to this type of PDE, when discounted appropriately, is actually a martingale. Thus the option price is the expected value of the discounted payoff of the option. Computing the option price via this expectation is the risk neutrality approach and can be done without knowledge of PDEs, it is not easy what you want. Good luck!