The Barone-Adesi and Whaley model is a quadratic approximation method used to price options. It is also known as the “Binomial Put Approximation” model. The model was developed in 1987 by Girolamo Barone-Adesi and Efraim Whaley.
The BA&W model works by approximating the underlying asset’s price distribution using a binomial tree. The model then uses this approximation to calculate the value of a put option.
To use the BA&W model, the trader must first specify the number of periods, or “n.” The number of periods corresponds to the number of “steps” in the binomial tree. The greater the number of periods, the more accurate the approximation will be.
The trader must also specify the asset’s price at each period. The prices used should be reasonable estimates of where the asset price is likely to be at each time period.
Once the number of periods and asset prices have been specified, the model can be used to calculate the value of a put option. The model takes into account the option’s strike price, expiration date, and interest rate. It also uses the volatility of the underlying asset to determine the option’s value.
The BA&W model is a useful tool for pricing options. However, it is important to note that the model is only an approximation. The actual value of an option may be different from the value calculated using the model.
The model is also only applicable to European-style options. These are options that can only be exercised on the expiration date. American-style options, which can be exercised at any time before expiration, cannot be priced using the BA&W model.
Despite these limitations, the BA&W model is a useful tool for pricing options. It is simple to use and can provide reasonably accurate results.