Lecture 10

Sergei Fedotov

20912 - Introduction to Financial Mathematics

Sergei Fedotov (University of Manchester) 20912 2010 1/7

 Lecture 10

1 Binomial Model for Stock Price

2 Option Pricing on Binomial Tree

3 Matching Volatility with u and d

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 Binomial model for the stock price
Continuous random model for the stock price: dS = Sdt + SdW

Sergei Fedotov (University of Manchester) 20912 2010 3/7

 Binomial model for the stock price
Continuous random model for the stock price: dS = Sdt + SdW

The binomial model for the stock price is a discrete time model:

The stock price S changes only at discrete times t, 2t, 3t, ...

Sergei Fedotov (University of Manchester) 20912 2010 3/7

 Binomial model for the stock price
Continuous random model for the stock price: dS = Sdt + SdW

The binomial model for the stock price is a discrete time model:

The stock price S changes only at discrete times t, 2t, 3t, ...

The price either moves up S Su or down S Sd with d < e r t < u.

Sergei Fedotov (University of Manchester) 20912 2010 3/7

 Binomial model for the stock price
Continuous random model for the stock price: dS = Sdt + SdW

The binomial model for the stock price is a discrete time model:

The stock price S changes only at discrete times t, 2t, 3t, ...

The price either moves up S Su or down S Sd with d < e r t < u.

The probability of up movement is q.

Sergei Fedotov (University of Manchester) 20912 2010 3/7

 Binomial model for the stock price
Continuous random model for the stock price: dS = Sdt + SdW

The binomial model for the stock price is a discrete time model:

The stock price S changes only at discrete times t, 2t, 3t, ...

The price either moves up S Su or down S Sd with d < e r t < u.

The probability of up movement is q.

Let us build up a tree of possible stock prices. The tree is called a binomial
tree, because the stock price will either move up or down at the end of
each time period. Each node represents a possible future stock price.

Sergei Fedotov (University of Manchester) 20912 2010 3/7

 Binomial model for the stock price
Continuous random model for the stock price: dS = Sdt + SdW

The binomial model for the stock price is a discrete time model:

The stock price S changes only at discrete times t, 2t, 3t, ...

The price either moves up S Su or down S Sd with d < e r t < u.

The probability of up movement is q.

Let us build up a tree of possible stock prices. The tree is called a binomial
tree, because the stock price will either move up or down at the end of
each time period. Each node represents a possible future stock price.

We divide the time to expiration T into several time steps of duration

t = T /N, where N is the number of time steps in the tree.

Sergei Fedotov (University of Manchester) 20912 2010 3/7

 Binomial model for the stock price
Continuous random model for the stock price: dS = Sdt + SdW

The binomial model for the stock price is a discrete time model:

The stock price S changes only at discrete times t, 2t, 3t, ...

The price either moves up S Su or down S Sd with d < e r t < u.

The probability of up movement is q.

Let us build up a tree of possible stock prices. The tree is called a binomial
tree, because the stock price will either move up or down at the end of
each time period. Each node represents a possible future stock price.

We divide the time to expiration T into several time steps of duration

t = T /N, where N is the number of time steps in the tree.

Example: Let us sketch the binomial tree for N = 4.

Sergei Fedotov (University of Manchester) 20912 2010 3/7
 Stock Price Movement in the Binomial Model

We introduce the following notations:

Snm is the n-th possible value of stock price at time-step mt.

Sergei Fedotov (University of Manchester) 20912 2010 4/7

 Stock Price Movement in the Binomial Model

We introduce the following notations:

Snm is the n-th possible value of stock price at time-step mt.

Then Snm = u n d mn S00 , where n = 0, 1, 2, ..., m.

S00 is the stock price at the time t = 0. Note that u and d are the same at
every node in the tree.

Sergei Fedotov (University of Manchester) 20912 2010 4/7

 Stock Price Movement in the Binomial Model

We introduce the following notations:

Snm is the n-th possible value of stock price at time-step mt.

Then Snm = u n d mn S00 , where n = 0, 1, 2, ..., m.

S00 is the stock price at the time t = 0. Note that u and d are the same at
every node in the tree.

For example, at the third time-step 3t, there are four possible stock
prices: S03 = d 3 S00 , S13 = ud 2 S00 , S23 = u 2 dS00 and S33 = u 3 S00 .

At the final time-step Nt, there are N + 1 possible values of stock price.

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 Call Option Pricing on Binomial Tree

We denote by Cnm the n-th possible value of call option at time-step mt.

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 Call Option Pricing on Binomial Tree

We denote by Cnm the n-th possible value of call option at time-step mt.

Risk Neutral Valuation (backward in time):

Cnm = e r t pCn+1
m+1
+ (1 p)Cnm+1 .

e rt d
Here 0 n m and p = ud .

Sergei Fedotov (University of Manchester) 20912 2010 5/7

 Call Option Pricing on Binomial Tree

We denote by Cnm the n-th possible value of call option at time-step mt.

Risk Neutral Valuation (backward in time):

Cnm = e r t pCn+1
m+1
+ (1 p)Cnm+1 .

e rt d
Here 0 n m and p = ud .

Final condition: CnN = max SnN E , 0 , where n = 0, 1, 2, ..., N, E is the

strike price.

Sergei Fedotov (University of Manchester) 20912 2010 5/7

 Call Option Pricing on Binomial Tree

We denote by Cnm the n-th possible value of call option at time-step mt.

Risk Neutral Valuation (backward in time):

Cnm = e r t pCn+1
m+1
+ (1 p)Cnm+1 .

e rt d
Here 0 n m and p = ud .

Final condition: CnN = max SnN E , 0 , where n = 0, 1, 2, ..., N, E is the

strike price.

The current option price C00 is the expected payoff in a risk-neutral world,
discounted at risk-free rate r : C00 = e rT Ep [CT ] .

Example: N = 4.

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 Matching volatility with u and d
We assume that the stock price starts at the value S0 and the time step is
t. Let us findthe expected stock price, E [S] , and the variance of the
return, var SS , for continuous and discrete models.

Sergei Fedotov (University of Manchester) 20912 2010 6/7

 Matching volatility with u and d
We assume that the stock price starts at the value S0 and the time step is
t. Let us findthe expected stock price, E [S] , and the variance of the
return, var SS , for continuous and discrete models.

Expected stock price: Continuous model: E [S] = S0 e t .

Sergei Fedotov (University of Manchester) 20912 2010 6/7

 Matching volatility with u and d
We assume that the stock price starts at the value S0 and the time step is
t. Let us findthe expected stock price, E [S] , and the variance of the
return, var SS , for continuous and discrete models.

Expected stock price: Continuous model: E [S] = S0 e t .

On the binomial tree: E [S] = qS0 u + (1 q)S0 d.

Sergei Fedotov (University of Manchester) 20912 2010 6/7

 Matching volatility with u and d
We assume that the stock price starts at the value S0 and the time step is
t. Let us findthe expected stock price, E [S] , and the variance of the
return, var SS , for continuous and discrete models.

Expected stock price: Continuous model: E [S] = S0 e t .

On the binomial tree: E [S] = qS0 u + (1 q)S0 d.

First equation: qu + (1 q)d = e t .

Sergei Fedotov (University of Manchester) 20912 2010 6/7

 Matching volatility with u and d
We assume that the stock price starts at the value S0 and the time step is
t. Let us findthe expected stock price, E [S] , and the variance of the
return, var SS , for continuous and discrete models.

Expected stock price: Continuous model: E [S] = S0 e t .

On the binomial tree: E [S] = qS0 u + (1 q)S0 d.

First equation: qu + (1 q)d = e t .

 S 
Variance of the return: Continuous model: var S = 2 t (Lecture2)

Sergei Fedotov (University of Manchester) 20912 2010 6/7

 Matching volatility with u and d
We assume that the stock price starts at the value S0 and the time step is
t. Let us findthe expected stock price, E [S] , and the variance of the
return, var SS , for continuous and discrete models.

Expected stock price: Continuous model: E [S] = S0 e t .

On the binomial tree: E [S] = qS0 u + (1 q)S0 d.

First equation: qu + (1 q)d = e t .

Variance of the return: Continuous model: var S = 2 t (Lecture2)

 
 S  S
On the binomial tree: var S =
q(u 1)2 + (1 q)(d 1)2 [q(u 1) + (1 q)(d 1)]2 =
qu 2 + (1 q)d 2 [qu + (1 q)d]2 .

Recall: var [X ] = E X 2 [E (X )]2 .

 

Sergei Fedotov (University of Manchester) 20912 2010 6/7

 Matching volatility with u and d
We assume that the stock price starts at the value S0 and the time step is
t. Let us findthe expected stock price, E [S] , and the variance of the
return, var SS , for continuous and discrete models.

Expected stock price: Continuous model: E [S] = S0 e t .

On the binomial tree: E [S] = qS0 u + (1 q)S0 d.

First equation: qu + (1 q)d = e t .

Variance of the return: Continuous model: var S = 2 t (Lecture2)

 
 S  S
On the binomial tree: var S =
q(u 1)2 + (1 q)(d 1)2 [q(u 1) + (1 q)(d 1)]2 =
qu 2 + (1 q)d 2 [qu + (1 q)d]2 .

Recall: var [X ] = E X 2 [E (X )]2 .

 

Second equation: qu 2 + (1 q)d 2 [qu + (1 q)d]2 = 2 t.

Sergei Fedotov (University of Manchester) 20912 2010 6/7

 Matching volatility with u and d
We assume that the stock price starts at the value S0 and the time step is
t. Let us findthe expected stock price, E [S] , and the variance of the
return, var SS , for continuous and discrete models.

Expected stock price: Continuous model: E [S] = S0 e t .

On the binomial tree: E [S] = qS0 u + (1 q)S0 d.

First equation: qu + (1 q)d = e t .

Variance of the return: Continuous model: var S = 2 t (Lecture2)

 
 S  S
On the binomial tree: var S =
q(u 1)2 + (1 q)(d 1)2 [q(u 1) + (1 q)(d 1)]2 =
qu 2 + (1 q)d 2 [qu + (1 q)d]2 .

Recall: var [X ] = E X 2 [E (X )]2 .

 

Second equation: qu 2 + (1 q)d 2 [qu + (1 q)d]2 = 2 t.

Third equation: u = d 1 .
Sergei Fedotov (University of Manchester) 20912 2010 6/7
 Matching volatility with u and d
e t d
From the first equation we find q = ud .

This is the probability of an up movement in the real world.

Sergei Fedotov (University of Manchester) 20912 2010 7/7

 Matching volatility with u and d
e t d
From the first equation we find q = ud .

This is the probability of an up movement in the real world. Substituting

this probability into the second equation, we obtain

e t (u + d) ud e 2t = 2 t.

Sergei Fedotov (University of Manchester) 20912 2010 7/7

 Matching volatility with u and d
e t d
From the first equation we find q = ud .

This is the probability of an up movement in the real world. Substituting

this probability into the second equation, we obtain

e t (u + d) ud e 2t = 2 t.
Using u = d 1 , we get
1
e t (u + ) 1 e 2t = 2 t.
u
This equation can be reduced to the quadratic equation. (Exercise sheet 4,
part 5).

Sergei Fedotov (University of Manchester) 20912 2010 7/7

 Matching volatility with u and d
e t d
From the first equation we find q = ud .

This is the probability of an up movement in the real world. Substituting

this probability into the second equation, we obtain

e t (u + d) ud e 2t = 2 t.
Using u = d 1 , we get
1
e t (u + ) 1 e 2t = 2 t.
u
This equation can be reduced to the quadratic equation. (Exercise sheet 4,
part 5).
One can obtain u e t 1 + t and d e t .

These are the values of u and d obtained by Cox, Ross, and Rubinstein in
1979.

Recall: e x 1 + x for small x.

Sergei Fedotov (University of Manchester) 20912 2010 7/7