Applications in finance

Binomial Option Pricing One of the most basic fundamental applications of decision tree analysis is for the purpose of option pricing. The binomial option pricing model uses discrete probabilities to determine the value of an option at expiration. The most basic binomial models assume that the value of the underlying asset will either move up or down, based on calculated probabilities, at the maturity date of the European option. Based on these expected payoff values, the price of the option can easily be determined.

Figure 2: Binomial Option Pricing However, the situation becomes much more complex with American options, when the option can be exercised at any point until maturity. The binomial tree would factor in multiple paths that the underlying asset's price can take as time progresses. For example, the price can move up, down, down, up, up or any other combination of infinite paths. At every point in time, the future value of the option will be determined by the price path taken by the underlying security. Furthermore, the final price of the security is not limited to only two potential final values as in the above example. As the number of nodes in the binomial decision tree increases, eventually the model converges onto the Black-Scholes formula.

Figure 3: Black Scholes Although the Black-Scholes formula provides an easier alternative to option pricing over

decision trees, software is available which can create a binomial option pricing model with "infinite" nodes. This type of calculation often provides more accurate pricing information, especially for Bermuda Options and dividend paying stocks. (Find out how to carve your way into this valuation model niche. See Breaking Down Binomial Trees.) Real Option Analysis Valuing real options, such as expansion options and abandonment options, must be done with the use of decision trees as their value cannot be determined via the Black-Scholes formula. Real options represent an actual decision that a company has the option to make - whether to expand or contract operations. Expansion (contraction) options are embedded in the project. For example, an oil and gas company can purchase a piece of land today and if drilling operations are successful it can buy an additional lot of land for a cheap price. If drilling is unsuccessful, the company will not exercise the option and it will expire worthless. Since real options provide significant value to corporate projects, they are an integral part of the capital budgeting decision.

Figure 4: Real Option Analysis The decision of whether to purchase the option or not must usually be decided prior to project initiation. However, once the probabilities of success and failures are determined, decision trees can help clarify what the expected value is of potential capital budgeting decision. Companies will often accept what initially seems like negative net present value projects, but once the real option value is considered, the NPV actually becomes positive. A primary advantage of decision tree analysis is that it provides a comprehensive overview for the alternative scenarios of a decision. Competing Projects Similarly, decision trees are also applicable to marketing and business development operations. The general setting for these types of cases is similar to that of real option pricing. Basically, companies are constantly making decisions regarding product expansion, marketing operations, international expansion, international contraction, hiring employees or even merging with another company. Organizing all considered alternatives with a decision tree allows for a systematic means to evaluate these ideas simultaneously. This is not to suggest that when a business decides whether or not to hire an additional worker, a decision tree is used every time. However, decision tree do provide a general framework on how

to go about determining the ideal solution to a problem and can help managers realize the consequences, either positive or negative, of their decision. For example, by formulating the issue of hiring additional staff with a decision tree, managers can determine the expected financial impact of such cases as hiring an employee who does not meet expectations and thus has to be let go. Essentially, this type of investigation can be used as a sensitivity analysis to quantify the impact of a wide range of uncertain variables. (How can you assign a value to what a company may do with its business in the future? We explain how it works. Check out Pin Down Stock Price With Real Options.) Pricing of Interest Rate Instruments Although not strictly a decision tree, a binomial tree is constructed in similar fashion and is used for similar purposes to determine the impact of a fluctuating/uncertain variable. The upward and downward movement of interest rates has a significant impact on the price of fixed income securities and interest rate derivatives. Binomial trees enable investors to accurately valuate bonds with embedded call and put provisions using uncertainty regarding future interest rates.

Figure 5: Pricing Interest Rate Instruments Because the Black-Scholes model is not applicable to valuating bonds and interest rate based options, the binomial model is the ideal alternative. Corporate projects are often valued with decision trees which factor various possible alternative states of the economy. Likewise the value of bonds, interest rate floors and caps, interest rate swaps and other type of investment tools can be determined by analyzing the effects of different interest rate environments. Corporate Analysis Decision trees not only provide a useful investment tool, but also enable one to explore the ranging elements that could have a material impact of a decision. Prior to airing a multi-million Super-Bowl commercial, a firm will want to determine the different possible outcomes of their marketing campaign. The various issues which can influence the final success or failure of the expenditure can include such factors as: appeal of the commercial, state of the economy, actual quality of the product (for long term profitability) and similar competitor advertisements. Once the impact of these variables has been determined and

the corresponding probabilities assigned, the company can make an informed decision as to whether or not proceed with the commercial. (Calculate whether the market is paying too much for a particular stock. Refer to DCF Valuation: The Stock Market Sanity Check.)

Figure 6: Corporate Analysis Conclusion The above example provides an overview of a typical assessment which can benefit from utilizing a decision tree. Once all of the important variables are determined, these decisions trees become very complex. However, these instruments are often an essential tool in the investment analysis or management decision making process. Read more: http://www.investopedia.com/articles/financial-theory/11/decisions-treesfinance.asp#ixzz1W6Isad24

Example

Decision trees are graphical representations of alternative choices that can be made by a business, which enable the decision maker to identify the most suitable option in a particular circumstance. For example, they will be used when oil and gas exploration companies have to decide whether to invest in a particular gas field, or in choosing to allocate resources to exploiting one gas field rather than another. Decision trees are a helpful visual tool when it is possible to measure the probability of an event occurring and the likely financial outcomes of making a particular decision. An oil exploration company has 100 million available in cash. It can invest the money in a bank at 10% yielding a return of 150 million over five years (ignore compound interest).

Alternatively it can invest in an oil exploration project, of which there are currently two available. If it invests in Project A there is a 0.5 chance of the project being a success yielding 200 million, and a 0.5 chance of the project failing leading to a loss of 50 million.(over the five year period) If it invests in Project B there is a 0.6 chance of the project being a success yielding 300 million and a 0.4 chance of the project failing leading to a loss of 20 million. (over the five year period) We can now work out the likely expected values: Invest in bank: 1.0 x 150m = 150m Project A 0.5 x 200 = 100m 0.5 x -50 = 25m = 100m Project B 0.6 x 300 = 180m 0.4 x -20 = -8m = 172m You can see that Project B yields the best result. We can illustrate this information on a decision tree. We set out the tree initially by working from left to right, the decision fork is to invest, or go for Project A or B. There are then chance forks where probabilities are involved. When we have set out the tree we can prune it back by cutting off the branches which yield the worst results. This leaves us with the final expected value - 172m which we put in the box at the start of the diagram.