Pricing the Pre-termination Option in Deposits: An Adaptation of the Binomial Option Pricing Model

Abstract

Bank deposits contain an option which allows the depositor to break the deposit prior to maturity and reinvest the funds at a higher yield.  How much is this option worth?  This is the question that this paper tries to answer by applying the Binomial Option Pricing Model (BOPM).  A price for the pre-termination option was determined and shown to be “correct” in the sense that an arbitrage opportunity is not present at that price.  The surprising, counter-intuitive result is that the option price is invariant relative to pre-termination penalties.  Why this is so is a matter that may merit further analysis.