Binomial Option Pricing Models

1
 A Simple Binomial Model

 A stock price is currently $20

 In 3 months it will be either $22 or $18

Stock Price = $22

Stock price = $20
Stock Price = $18

2
 A Call Option

A 3-month call option on the stock has a strike

price of 21.

Stock Price = $22

Option Payoff = $1
Stock price = $20
Option Price=?
Stock Price = $18
Option Payoff = $0

3
Setting Up a Riskless Portfolio
 For a portfolio that is long D shares, and a
short 1 call option values are

22D – 1

18D

Portfolio is riskless when 22D – 1

= 18D or D = 0.25
4
 Valuing the Portfolio
(Risk-Free Rate is 4%)

 The riskless portfolio is:

long 0.25 shares
short 1 call option
 The value of the portfolio in 3 months is
22 ×0.25 – 1 = 4.50
 The value of the portfolio today is
4.5e–0.04×0.25 = 4.455

5
Valuing the Option
 The portfolio that is
long 0.25 shares
short 1 option
is worth 4.455
 The value of the shares is
5.00 (= 0.25 × 20 )
 The value of the option is therefore
5.00 – 4.455 = 0.545

6
 Generalization

A derivative lasts for time T and is

dependent on a stock
S0u
ƒu
S0
ƒ
S0d
ƒd

7
Generalization
 Value of a portfolio that is long D shares and short
1 derivative:

S0uD – ƒu

S0dD – ƒd

 The portfolio is riskless when S0uD – ƒu = S0dD – ƒd

or
ƒu − f d
D=
S 0u − S 0 d

8
Generalization
 Value of the portfolio at time T is S0uD
– ƒu
 Value of the portfolio today is (S0uD –
ƒu)e–rT
 Another expression for the portfolio
value today is S0D – f
 Hence
ƒ = S0D – (S0uD – ƒu )e–rT
9
 Generalization
(continued)

Substituting for D we obtain

ƒ = [ pƒu + (1 – p)ƒd ]e–rT

where
e rT − d
p=
u−d

10
p as a Probability
 It is natural to interpret p and 1-p as probabilities of up
and down movements
 The value of a derivative is then its expected payoff in
a risk-neutral world discounted at the risk-free rate
S0u
ƒu
S0
ƒ
S0d
ƒd

11
Risk-Neutral Valuation
 When the probability of an up and down
movements are p and 1-p the expected stock price
at time T is S0erT
 This shows that the stock price earns the risk-free
rate
 Binomial trees illustrate the general result that to
value a derivative we can assume that the
expected return on the underlying asset is the risk-
free rate and discount at the risk-free rate
 This is known as using risk-neutral valuation

12
Original Example Revisited
S0u = 22
ƒu = 1
S0=20
ƒ
S0d = 18
ƒd = 0

p is the probability that gives a return on the stock equal to the

risk-free rate:
20e 0.04 ×0.25 = 22p + 18(1 – p ) so that p = 0.5503
Alternatively: 0.040.25
e −d e
rT
− 0.9
p= = = 0.5543
u−d 1.1 − 0.9

13
 Valuing the Option Using Risk-Neutral
Valuation

S0u = 22
ƒu = 1
S0=20
ƒ
S0d = 18
ƒd = 0

The value of the option is

e–0.04×0.25 (0.5543 ×1 + 0.4497×0)
= 0.545

14
A Two-Step Example

24.2
22

20 19.8

18
16.2

 K=21, r = 4%
 Each time step is 3 months

15
 Valuing a Call Option

24.2
3.2
22
B
20 1.7433 19.8
0.9497 A 0.0
18

0.0 16.2
0.0
Value at node B
= e–0.04×0.25(0.5503×3.2 + 0.4497×0) = 1.7433
Value at node A
= e–0.04×0.25(0.5503×1.7433 + 0.4497×0) = 0.9497

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17
18
Example: Put Option
 Consider a 2-year put option with strike
price of Rs.52 on a stock whose current
price is Rs.50. Suppose that there are two
times of 1 year, and each time step the
stock price either moves up by 20% or
moves down by 20%. The risk-free rate is
5%.

19
 A Put Option Example

72
0
60
50 1.4147 48
4.1923 4
40
9.4636 32
20

K = 52, time step =1yr

r = 5%, u =1.2, d = 0.8

20
 What Happens When the Put Option
is American

72
0
60

50 1.4147 48
5.0894 4
40
The American feature C
increases the value at node 12.0 32
C from 9.4636 to 12.0000. 20

This increases the value of

the option from 4.1923 to
5.0894.

21
 Delta

 Delta (D) is the ratio of the change

in the price of a stock option to the
change in the price of the
underlying stock
 The value of D varies from node to
node

22
Choosing u and d
One way of matching the volatility is to
set

u = es Dt

d = 1 u = e −s Dt

where s is the volatility and Dt is the

length of the time step. This is the
approach used by Cox, Ross, and
Rubinstein
23
Assets Other than Non-Dividend
Paying Stocks

 For options on stock indices, currencies

and futures the basic procedure for
constructing the tree is the same except
for the calculation of p

24
 The Probability of an Up Move

a−d
p=
u−d

a = e rDt for a nondividen d paying stock

a = e ( r − q ) Dt for a stock index where q is the dividend

yield on the index

( r − r ) Dt
a=e f for a currency where r f is the foreign
risk - free rate

a = 1 for a futures contract

25
Example
 Consider an American put option where
the stock price is Rs.50, the strike price is
Rs.52, the risk-free rate is 5%, the life of
the option is 2 years, and there are two-
time steps. The volatility is 30%.

26
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28
Example
A stock index is currently 810 and has a
volatility of 20% and dividend yield of 2%.
The risk-free rate of interest is 5%.
Determine the value of the European call
option with a strike price 800 using two
step binomial tree.

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