One Period Binomial Asset Pricing Model

(FE543 Intro to Stochastic Calculus for Finance)

Papa Momar Ndiaye

Stevens Institute of Technology

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
 1 One Period Binomial Pricing Model
The Model
Non Arbitrage

2 Pricing Derivatives
European Call Option
Non Arbitrage Pricing
Replicating Portfolio
Risk Neutral Probabilities
Delta Hedging

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
The Model

At time 0 we have initial stock price S0 , which at time 1 can move to one of
two possible states S1 (H) or S1 (T ).

This transition is through the tossing of a coin with probability p of "heads"

and 1 − p = q of "tails."

We can introduce two new values

S1 (H) S1 (T )
u= ;d =
S0 S0

We can think of u as the "up factor" and d as the "down factor."

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
The Model

We also introduce the interest rate r , such that an initial investment of X0 will
earn (1 + r )X0 at time 1. The key point is to avoid arbitrage, as any model that
admits arbitrage is useless for analysis.

Arbitrage: A trading strategy that begins with no money, has zero probability
of losing money, and has a positive probability of making money.[1]
For our one period model, to prevent arbitrage we enforce

0<d <1+r <u

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
The Model

If this wasn’t true,

d ≥ 1 + r , one begins with zero wealth and borrow money to buy the stock at
time zero. At time 1, the trader owes (1 + r )S0 ≤ S0 d = S1 (T ), so the debt is
paid even if the worst toss is made, but profit is made if a better toss happens.

u ≤ 1 + r , short the stock and invest the money into the money market. The
trader will earn S0 (1 + r ) ≥ S0 u = S1 (H) so the trader can then buy the stock
to cover the short and at the very worst break even and possibly make money

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
The Model

It is common to have d = u1 but this isn’t mandatory. The purpose of using this
approach even though the actual stock behavior is more complicated is multifold:
1 Very clear visualization of arbitrage and its relation to risk-neutral
pricing
2 With enough periods, the model does provide a "reasonably good"
computationally tractable approximation to real-time models.
3 Within this model, we can develop the theory of martingales and conditional
expectations

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
European Call Option

European Call Option: confers the right but not the obligation to purchase one
share of stock at a strike price K at a fixed future time.
For the one period case, we will consider the expiration of the option to be one
time step and observe how best to price this option. Because this is an option as
opposed to a future, there is no reason to exercise the option if it would result in a
loss of money. As such the value of the option will be (S1 − K )+ . To price the
option, we will utilize the arbitrage pricing theory approach which entails
simulating the behavior of the option using positions in the underlying stock and
the money market.

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
European Call Option

Example 1.1.1: Let S0 = 4, u = 2, d = 12 , and r = 14 . Show that an initial wealth

of X0 = 1.2 and a share ∆0 = 21 result in a replicated option with strike K = 5.

X1 (H) = ∆0 S1 (H) + (1 + r )(X0 − ∆0 S0 ) = 3

X1 (T ) = ∆0 S1 (T ) + (1 + r )(X0 − ∆0 S0 ) = 0
So either way, our position in the stock and money market are identical to the
values of the option. This value X0 is the no arbitrage price of the option, as any
other price would result in arbitrage.

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
Non Arbitrage Pricing

The above arbitrage pricing theory depends on the assumptions

1 shares of stock can be subdivided for sale or purchase

2 interest rate for investing is the same as for borrowing

3 purchase price of a stock is the same as the selling price

4 at any time, the stock will only take one of two values in the next time period

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
 1 The assumptions 1-3 are used in the Black-Scholes-Merton option pricing
formula (fourth assumption is replaced with geometric Brownian motion
(GBM)).
2 The first assumption is functionally true, the second is close to being true for
large institutions, but the third one does not hold true in practice.
3 Derivative Security: a security that pays some amount V1 (H) at time 1 if
"heads" and a possibly different amount V1 (T ) if "tails." E.g. European
options and forwards

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
Replicating Portfolio

To find the price V0 at time 0 we replicate the stock as we did previously.

1 Begin with an initial wealth X0 and trade ∆0 shares of stock

2 Invest X0 − ∆0 S0 in the money market.

3 This will lead us to having at time 1, letting ω represent the outcome of the
toss of the coin:

X1 (ω) = ∆0 S1 (ω) + (1 + r )(X0 − S0 ∆0 ) = (1 + r )X0 + ∆0 (S1 (ω) − (1 + r )S0 )

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
Replicating Portfolio

1 The goal is to choose X0 and ∆0 in such a way as to have X1 (H) = V1 (H) and
X1 (T ) = V1 (T ). This will give us the value of V0 = X0 that will result in an
arbitrage free situation.
2 If we divide the previous equation by (1 + r ) and replace the X1 (ω) with the
values of V1 we have the equations;

1 1
X0 + ∆0 ( S1 (H) − S0 ) = V1 (H) (1)
1+r 1+r
1 1
X0 + ∆0 ( S1 (T ) − S0 ) = V1 (T ) (2)
1+r 1+r

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
Replicating Portfolio

We then introduce two new non-negative values which we label p̃ and q̃ such
that p̃ + q̃ = 1.

1 We multiply (1) by p̃ and multiply (2) by q̃ and add the two equations together.

2 This gives us the equation:

 
1 1
X0 + ∆0 [p̃S1 (H) + q̃S1 (T )] − S0 = [p̃V1 (H) + q̃V1 (T )] (3)
1+r 1+r

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
Risk Neutral Probabilities

We choose the parameters p̃ and q̃ such that the term multiplied by ∆0 is zero. To
this end we set
1
S0 = (p̃S1 (H) + q̃S1 (T ))
1+r
1
= (p̃uS0 + q̃dS0 )
1+r
1
= (p̃uS0 + (1 − p̃)dS0 )
1+r
1
1= (p̃u + (1 − p̃)d)
1+r
1+r −d
p̃ =
u−d
u−1−r
q̃ =
u−d
(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
Risk Neutral Probabilities

With these values for p̃ and q̃, we have (3) now as

1
X0 = V0 = [p̃V1 (H) + q̃V1 (T )]
1+r
These values for p̃ and q̃ are called the risk-neutral probabilities, as we can see
from our equations that:

(1 + r )S0 = (p̃S1 (H) + q̃S1 (T ))

Or that under these value, the expected value of the stock at time 1 under these
probabilities is equal to the amount earned by the risk-free interest rate.

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
Delta Hedging

Also from (1) and (2) we can subtract these two equations from each other and
determine that
V1 (H) − V1 (T )
∆0 =
S1 (H) − S1 (T )
which together with the X0 gives us our delta-hedging portfolio to match the
value of the derivative security for any possibility. This process for determining the
value of V0 is called the risk-neutral pricing formula. Note that the risk-neutral
probabilities are not the true probabilities.

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
 Under the true probabilities, you should expect to make more than what you would
earn from putting you money in the money market, otherwise there is no reason to
invest in the stock or option. We can express this using:

1
S0 < (pS1 (H) + qS1 (T ))
1+r

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model
 [1] S.E. Shreve. Stochastic Calculus for Finance I: The Binomial Asset Pricing
Model. Number v. 1 in Springer Finance. Springer, 2004.

(FE543 Intro to Stochastic Calculus for Finance) Papa Momar Ndiaye One Period Binomial Asset Pricing Model