The Binomial Option Pricing Model (BOPM) provides a powerful tool for un-

derstanding arbitrage pricing theory and probability theory. We use the

model to study useful facts regarding the Fundamental Theorem of Arbitrage

Pricing (FTAP).

The foregoing statements yield three key reasons (a - c below) that have been

known to underpin the use of the BOPM. Illustrate each of the uses using

suitable workings.

(a) The BOPM clearly outlines the concept of arbitrage pricing and its rela-

tion to risk neutral pricing

(b) The model is used in practice because with sufficient number of steps, it

provides a good, computationally tractable approximation to continuous

time models

(c) Within the binomial model we can develop the theory of conditional ex-

pectations and martingales which are at the heart of continuous time models