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

Bienvenido M. Aragon

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.

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