Multi-period binomial asset pricing model 217After a coin toss, the agent can readjust her replicating portfolio. Thus, in order to determine the no-arbitrage price of the derivative at time zero we can proceed viabackwardinduction, i.e. we determine the no-arbitrage price of the derivative for each sub-tree starting at the very right and work “backward” to the very left.
Additional assumption as compared to the one-period case:u and d are constant: Since u and d measure the volatility of theunderlying, we implicitly assume that this volatility is constant!This is empirically not justified!
After a coin toss, the agent canreadjust her replicatingportfolio at no cost.Derivative securities: Options - Binomial asset pricing model