Risk-Neutral Valuation: Steven Skiena

Lecture 11:
Risk-Neutral Valuation
Steven Skiena
Department of Computer Science

State University of New York
Stony Brook, NY 11794–4400
http://www.cs.sunysb.edu/∼skiena
Risk-Neutral Probabilities
We can use an arbitrage argument to set the “right”
probability of an upward move (β) as a function of the risk-
free rate.
At any point, investors can either (a) hold $1 stock or (b)
invest $1 at the risk-free rate r.
A risk-neutral investor would not care which portfolio they
owned if they had the same return.
Setting equal the returns from the stock (βα + (1 − β)/α) and
the risk-free portfolio (1 + r), we can solve for β to determine
the risk-neutral probability.
But in truth, investors are not risk-neutral. In order to take the
riskier investment they must be paid a premium.
Single-Step Option Pricing
Binomial trees price options using the idea of risk-neutral
valuation.
Suppose a stock price is currently at $20, and will either be at
$22 or $18 in three months.
What is the price of a European call option for a strike price
of $21? Clearly, this reduces to determining the probability
of the upward price movement.
Risk Neutral Valuation
The risk-neutral investor argument for setting this probability
can be applied if we set up two portfolios which are of
provably of equal risk and value.
We will construct two riskless portfolios, one involving the
stock and the other the risk-free rate.
Using Options to Eliminate Risk
A riskless portfolio can be created by buying ∆ shares of
stock and selling a short position in 1 call option, such that
the value of the portfolio is the same whether the stock moves
up or down.
If the stock moves to $22, our portfolio will be worth
$22∆ − $1 · 1, since we must pay the return of the option
we sold.
If the stock moves to $18, our portfolio will be worth
$18∆ − $0, since the option we sold is worthless.
A riskless portfolio is constructed by buying ∆ = 0.25 shares,
since it is the solution of $22∆ − $1 · 1 = $18∆.
Valuing the Portfolio
Whether the stock goes up or down, this portfolio is worth
$4.50 at the end of the period.
The discounted value of this portfolio today, V , can
be computed given the risk-free interest rate r. Thus
V = (4.50)e−rt.
Since the value of V is equal to owning ∆ = 0.25 shares
of stock at $20 per share minus the value f of the option,
f = 20 · 0.25 − V .
The General Case
In general, if there is an upward price movement, the value at
the end of the option is
S0u∆ − fu
where S0u (fu) the price of the stock (option) after an upward
movement.
If there is a downward price movement, the value at the end
of the option is
S0d∆ − fd
Setting them equal and solving for ∆ yields
fu − fd
∆=
S0 u − S0 d
The present value of the portfolio with a risk-free rate of r is
(S0u∆ − fu)e−rT
which can be set up for a cost of S0∆ − f .
Equating these two and solving for f yields
f = S0∆ − (S0u∆ − fu)e−rT
By definition, the value of f must also be
f = e−rT (βfu + (1 − β)fd)
where β is the probability of an upward movement.
Solving for β we get
erT − d
β=
u−d
Interpreting this Probability
The expected stock price at time T implied by these
probabilities is S0erT .
This implies that the stock price earns the risk free rate.
The value of an option is its expected payoff in a risk-neutral
world discounted at the risk-free rate.
Irrelevance of Stock’s Expected Return
When we value an option in terms of the price of the
underlying asset, the probability of up and down movements
in the real world is irrelevant, since they can be hedged.
This is an example of a more general result stating that the
expected return (drift) on the underlying asset in the real
world is irrelevant.
The option has to have the risk-neutral valuation, because
if not there exists an arbitrage opportunity buying the right
portfolio.
Pricing Options with Binomial Trees
The value of the option can be worked backwards from the
terminating (basis) condition level by level.
The value of the option on leaf / terminating level is deter-

mined because the option price at expiration is completely
given by the stock and strike prices.
Finer Gradations
Adding additional levels to the trees allows finer price
gradations than just a single up or down.
The price of an option generally converges after about n = 30
levels or so.
Note that the number of options needed (∆) changes at each
node/level in the binomial tree. Thus to maintain a riskless
portfolio options must be bought and sold continuously, a
process known as delta hedging.
Generalizing the Model
This binomial tree model can be generalized to include the
effects of (1) dividends, by changing the magnitude of the
moves in the levels corresponding to dividend periods, (2)
changing interest rates, by using the rate appropriate on a
given yield curve.
It can also be generalized to allow more than two price
movements from each node, say increase, decrease, and
unchanged.
Pricing American Options
American options permit execution at any intermediate time
point.
It pays to exercise a non-dividend paying American put early
if the underlying stock price is sufficiently low (say 0) due to
time-value of money.
In general, it pays to exercise now whenever the payoff from
immediate execution exceeds the value computed for the
option at that point.
The options can be priced by using the higher of the two
possible valuations at any point in the tree.
American Put Example
Observe the difference between evaluating a put (S0 = 50,
strike price K = 52)) as European vs. American:
The price at each node is the maximum of SK − ST and its

European evaluation.
Early Exercise for American Calls
It can be proven that it never pays to execute an American call
option early.
Consider a single period for an American call. Start at S0 and
end at S0u or S0d, with payoff fu and fd where 0 < fd <
erT < fu.
The no exercise condition e−rT (pfu + (1 − p)fd) > S0 − K
clearly holds for K > S0. The two other cases are:
• S0 d < K ≤ S0
• K ≤ S0 d
Case I: S0d < K ≤ S0
• e−rT (pfu + (1 − p)fd ) ≥ e−rT pfu ≥ e−rT p(S0 u − K).
• Using p = (erT − d)/(u − d), we therefore need to prove
e−rT p(S0 u − K) > S0 − K

⇐⇒ (1 − e−rT p)K > (1 − e−rT pu)S0
⇐⇒ (u − d − 1 + de −rT )K > (ue−rT − 1)S0 d.
• Proof:
(u − d − 1 + de−rT )K > (u − d − 1 + de−rT )S0 d (1)

= (u − d − (u − d)e −rT
+ ue
−rT
− 1)S0 d (2)
= ((u − d)(1 − e −rT
) + ue −rT
− 1)S0 d (3)
> (ue −rT
− 1)S0 d. (4)
This completes the proof and shows that an American call would never be exercised early in this case.
Case II: K ≤ S0d
• We have fu ≥ S0 u − K, and fd ≥ S0 d − K.
• We therefore have
e−rT (pfu + (1 − p)fd ) ≥ e−rT (p(S0 u − K) + (1 − p)(S0 d − K)) (5)

= e −rT
((puS0 + (1 − p)dS0 ) − K) (6)
rT
= e −rT
(e S0 − K) (7)
= S0 − e −rT
K (8)
> S0 − K. (9)
(10)
This shows that American call can never be exercised early in this case either.
Why Monte Carlo Simulation?
Monte Carlo simulation is simpler than dynamic program-
ming to conceive or implement.
When the number of levels gets too high for exhaustive
dynamic programming computation (say n = 1, 000, 000),
Monte Carlo random walks can still be used to sample the
distribution.
Dynamic programming cannot as readily be applied to
compute path-dependent distributions (such as Hurst random
walks or pricing Asian options) as the state at each node
depends on the path used to get there.
How Much is Up (and Down)?
To complete the model, we need to set the magnitude for up
and down movements in the binomial tree.
If S0u < S0ert, the upside for stock ownership is too low, and
we are better off investing at the risk-free rate.
If S0d > S0ert, holding stock guarantees a better return than
the risk free rate!
Thus S0u > S0ert > S0d. Otherwise the probability formulae
give numbers outside of [0, 1].
This leaves us considerable freedom to set the u, d, and p
parameters.

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Lecture 11:

Department of Computer Science

The value of the option on leaf / terminating level is deter-

The price at each node is the maximum of SK − ST and its

• e−rT (pfu + (1 − p)fd ) ≥ e−rT pfu ≥ e−rT p(S0 u − K).

• Using p = (erT − d)/(u − d), we therefore need to prove

e−rT p(S0 u − K) > S0 − K

(u − d − 1 + de−rT )K > (u − d − 1 + de−rT )S0 d (1)

e−rT (pfu + (1 − p)fd ) ≥ e−rT (p(S0 u − K) + (1 − p)(S0 d − K)) (5)

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