A B C D E

1 Consider a call option on a stock. The stock's current price, denoted by P, is $40 and the strike price, denoted by X, is $35. The option
2 expires in 6 months. The risk-free rate is 8%.
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4 At expiration, the stock can take on only one of two possible values. It can either go up in price by a factor of 1.25, or down in price by a
5 factor of 0.80.
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7 Inputs:
8 Current stock price, P = $40.00
9 Nominal annual risk-free rate, rRF = 8%
10 Strike price, X = $35.00
11 Up factor for stock price, u = 1.25
12 Down factor for stock price, d = 0.80
13 Years to expiration, t = 0.50
14 Number of periods until expiration, n = 1
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19 Binomial Model
20 Strike price: X = $35.00
21 Current stock price: P = $40.00
22 Up factor for stock price: u = 1.25
23 Down factor for stock price: d = 0.80
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25 Ending up
26 stock price
27 P (u) = MAX[P(u) − X, 0] =
28 =D8*D11= $50.00 =MAX(D28-D20,0)=
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30 P, VC,
31 current current
32 stock price option price
33 $40 ?
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35 Ending down
36 stock price
37 P (d) =
38 =D8*D12= $32.00
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43 Riskless Portfolio
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46 Suppose we form a portfolio by writing 1 call option and purchasing N s shares of stock. We want to choose N s such that the payoff of the
47 portfolio if the stock price goes up is the same as if the stock price goes down. This is called a hedge portfolio because it has a riskless payoff
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55 P(u)Ns - Cu = P(d)Ns - Cd
 A B C D E
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61 Step 1. Find the number of shares of stock in the hedge portfolio.
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63 Ns = Cu - C d = 0.83333 =(G28-G38)/(D8*(D11-D12))
64 P(u - d)
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66 Step 2. Find the hedge portfolio’s payoff.
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70 The Hedge Portfolio with Riskless Payoffs
71 Strike price: X =
72 Current stock price: P =
73 Up factor for stock price: u =
74 Down factor for stock price: d =
75 Cu = MAX[0,P(u)-X] =
76 Cd =MAX[0,P(d)-X] =
77 Number of shares of stock in portfolio: N s = (Cu - Cd) / P(u-d) =
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79 Stock price = P (u) = $50.00
80 P, Portfolio's stock payoff: = P(u)(Ns) =
81 current Subtract Intrinsic value : Cu =
82 stock price Portfolio's net payoff = P(u)Ns - Cu =
83 $40
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87 Stock price = P (d) = $32.00
88 Portfolio's stock payoff: = P(d)(Ns) =
89 Subtract Intrinsic value : Cd =
90 Portfolio's net payoff = P(d)Ns - Cd =
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93 Step 3. Find the present value of the hedge portfolio's riskless payoff.
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95 The present value of the riskless payoff disounted at the risk-free rate is:
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97 Risk-free rate, rF: 8%
98 T: 0.5
99 Payoff of hedged portfolio: $26.6667
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101 PV of payoff = $25.6211 =D99*EXP(-D97*D98)
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104 Step 4. Find the option's current value.
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107 Value of Call option VC = Ns (P) - Present value of riskless payoff
108 VC = $7.71 =F77*F72-D101
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 A B C D E
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112 Binomial Option Pricing Formula
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117  e rRF ( t / n )  d   u  e rRF ( t / n ) 
118 Cu    Cd  
119 
 u d  
 u d 
120 VC  rRF ( t / n )
121 e
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123 Inputs:
124 P= $40.00 =A33
125 X= $35.00 =D20
126 u= 1.25 =D22
127 d= 0.80 =D23
128 Cu = $15.00 =F81
129 Cd = $0.00 =F89
130 Risk-free rate, rRF = 8% =D9
131 Years to expiration, t = 0.50 =D13
132 Number of periods until expiration, n = 1 =D14
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134 VC = $7.71 =((D128*((EXP(D130*D131/D132)-D127)/(D126-D127)))+(D129*((D
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136 The Simplified Binomial Option Pricing Formula
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138 P= $40.00 =A33
139 X= $35.00 =D20
140 u= 1.25 =D22
141 d= 0.80 =D23
142 Cu = $15.00 =D128
143 Cd = $0.00 =D129
144 Risk-free rate, rRF = 8% =D9
145 Years to expiration, t = 0.50 =D13
146 Number of periods until expiration, n = 1 =D14
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148 Alternative formula with pu and pd as:
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151  e rRF ( t / n )  d   u  e rRF ( t / n ) 
152    
153  u d  u d
 
154 u 
rRF ( t / n )  d 
e e rRF ( t / n )
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157 The binomial option pricing model then simplifies to:
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159 VC = Cu pu + Cd pd
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162 pu = 0.5142 =((EXP(D144*D145/D146)-D141)/($D$140-$D$141))/EXP(D144*D145/D146)
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164 pd = 0.4466 =((D140-EXP(D144*D145/D146))/($D$140-$D$141))/EXP(D144*D145/D146)
 A B C D E
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167 VC = Cu x pu +
168 VC = $15.00 x 0.5142 +
169 =D142 =C162
170 VC = $7.71 =B168*D168+F168*H168
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173 Multi-Period Binomial Option Pricing Model
174 s is the standard deviation of stock return. Here are the formulas relating s to to u and d:
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176 1
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178 u  e t/n d 
u
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181 Multi-period
182 Annual standard deviation of stock return, σ = 31.5573%
183 Years to expiration, t = 0.5
184 Number of periods prior to expiration, n = 2
185 u= 1.1709
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187 d= 0.8540
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189 Current stock price, P = $40.00
190 Risk-free rate, rRF = 8%
191 Strike price, X = $35.00
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194 Because we are going to solve a binomial problem repeatedly, it will be easier if we go ahead and calculate the pi's now.
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196 pu = 0.51400
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198 pd = 0.46620
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203 The 2-Period Binomial Lattice and Option Valuation
204 Standard deviation of stock return: σ = 31.5573%
205 Current stock price: P = $40.00
206 Up factor for stock price: u = 1.1709
207 Down factor for stock price: d = 0.8540
208 Strike price: X = $35.00
209 Risk-free rate: rRF = 8.00%
210 Years to expiration: t = 0.50
211 Number of periods until expiration: n = 2
212 πu = 0.51400
213 πd = 0.46620
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215 Now 3 months
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 A B C D E
220 Stock = P (u) = $46.84
221 Cu = Cuuπu + Cudπd
222 Cu = $12.53
223 P = $40.00 =I219*E212+I225*E213
224 VC=Cuπu+Cdπd
225 VC =
226 7.63841065832
227 Stock = P (d) = $34.16
228 Cd = Cudπu + Cddπd
229 Cd = $2.57
230 =I225*E212+I232*E213
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 A B C D E
236 Black-Scholes Option Pricing Model
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238 S0 $40.00 Current stock price
239 X $35.00 Exercise price
240 T 0.50 Time to maturity of option (in years)
 F G H I J K L M
1 strike price, denoted by X, is $35. The option
oted by P, is $40 and the
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ues. It can either go up 4in price by a factor of 1.25, or down in price by a
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24 C u,
25 ending up
26 Intrinsic value
27 MAX[P(u) − X, 0] =
28 =MAX(D28-D20,0)= $15.00
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34 C d,
35 ending down
36 Intrinsic value
37 MAX[P(d) − X, 0] =
38 =MAX(D38-D20,0)= $0.00
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sing N s shares of stock.46
We want to choose N s such that the payoff of the
47 a hedge portfolio because it has a riskless payoff.
ce goes down. This is called
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 F G H I J K L M
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. 61
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=(G28-G38)/(D8*(D11-D12))
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71 $35.00 =D10
72 $40.00 =D8
73 1.25 =D11
74 0.80 =D12
75 $15.00 =G28
76 $0.00 =G38
77 0.83333 =D63
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80 $41.67 =F72*F73*F77
81 $15.00 =F75
82 $26.67 =F80-F81
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88 $26.67 =F72*F74*F77
89 $0.00 =F76
90 $26.67 =F88-F89
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ayoff. 93
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ee rate is: 95
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=D99*EXP(-D97*D98)
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 F G H I J K L M
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116( t / n )
 u  e r117RF 
 Cd  118 
  d
u119 
t / n) 120
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=((D128*((EXP(D130*D131/D132)-D127)/(D126-D127)))+(D129*((D126-EXP(D130*D131/D132))/(D126-D127))))/EXP(D130*D131/D132)
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*D145/D146)-D141)/($D$140-$D$141))/EXP(D144*D145/D146)
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(D144*D145/D146))/($D$140-$D$141))/EXP(D144*D145/D146)
 F G H I J K L M
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167 Cd x pd
168 $0.00 x 0.4466
169 =D143 =C164
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las relating s to to u 174
and d:
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181 Single-period
182 31.5573%
183 0.5
184 1
185 1.2500
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187 0.8000
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189 40.000
190 8%
191 35.000
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will be easier if we go194
ahead and calculate the pi's now.
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196 =((EXP(E190*E183/E184)-E$187)/(E$185-E$187))/EXP(E190*E183/E184)
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198 =((E$185-EXP(E190*E183/E184))/(E$185-E$187))/EXP(E190*E183/E184)
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215 6 months
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217 Stock = P (u) (u) = $54.84 =E205*E206*E206
218 Cuu = Max[P(u)(u) − X, 0]
219 Cuu = $19.84 =MAX(I217-E208,0)
 F G H I J K L M
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222 Stock = P (u) (d) = P (d) (u)
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=I219*E212+I225*E213 Stock = $40.00 =E220*E207
224 Cud = Cdu = Max[P(u)(d) − X, 0]
225 Cud = $5.00 =MAX(I223-E208,0)
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=I225*E212+I232*E213 Stock = P (d) (d) = $29.17 =E227*E207
231 Cdd = Max[P(d)(d) − X, 0]
232 Cdd = $0.00 =MAX(I230-E208,0)
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 F G H I J K L M
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 N O P Q R S T
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 N O P Q R S T
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32))/(D126-D127))))/EXP(D130*D131/D132)
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Binomial Option Pricing

 e rRF ( t / n )  d  u  e rRF ( t / n )  1
Cu    C d 
 u d   u d 
u  e t/n d 
u
VC  rRF ( t / n )
e
Call Put Spot price is the current m
Spot = $489.90 $489.90 =D13
X= $495.00 $495.00 =D14
Implied Sigma 21% 21% =D15
u= 1.048757 =EXP($'Binomial ITC'.D15*SQRT1.0487572 =D16
d= 0.95 =1/D16 0.95 =D17
Pu = $513.79 =D13*D16 $513.79 =D18
Pd = $467.12 =D13*D17 $467.12 =D19
Cu = $18.79 =MAX(D18-D14,0) $0.00 =MAX(H14-H18,0)
Cd = $0.00 =MAX(D19-D14,0) $27.88 =MAX(H14-H19,0)
Risk-free rate, rRF = Err:501 =[1]black–Scholes!$B$5 6.53% =D22
Years to expiration, t = Err:501 =[1]black–Scholes!$B$4 Err:501 =D23
of periods until expiration, n = 1 1 =D24

VC = $9.84 $13.17
=((H20*((EXP(H22*(H23/H24))-H17)/(H16-H17)))+(H21*((H16-EXP(H22*H23/H2
=((D20*((EXP(D22*(D23/D24))-D17)/(D16-D17)))+(D21*((D16-EXP(D22*D23/D24))/(D16-D17))))/EXP(D22*D23/D24)

Call Put
Spot = $489.90 $489.90 =D32
X= $495.00 $495.00 =D33
Historical Sigma 19.69% 19.69% =D34
u= 1.045012 =EXP($'Binomial ITC'.D34*SQRT1.0450118 =D35
d= 0.96 =1/D35 0.96 =D36
Pu = $511.95 =D32*D35 $511.95 =D37
Pd = $468.80 =D32*D36 $468.80 =D38
Cu = $16.95 =MAX(D37-D33,0) $0.00 =MAX(H33-H37,0)
Cd = $0.00 =MAX(D38-D33,0) $26.20 =MAX(H33-H38,0)
Risk-free rate, rRF = Err:501 6.53% =D41
Years to expiration, t = Err:501 =[1]black–Scholes!$B$4 Err:501 =D42
of periods until expiration, n = 1 1 =D43

VC = $8.95 $12.28
=((H39*((EXP(H41*(H42/H43))-H36)/(H35-H36)))+(H40*((H35-EXP(H41*H42/H4
=((D39*((EXP(D41*(D42/D43))-D36)/(D35-D36)))+(D40*((D35-EXP(D41*D42/D43))/(D35-D36))))/EXP(D41*D42/D43)
 Spot price is the current market share price

H21*((H16-EXP(H22*H23/H24))/(H16-H17))))/EXP(H22*H23/H24)
))/EXP(D22*D23/D24)

H40*((H35-EXP(H41*H42/H43))/(H35-H36))))/EXP(H41*H42/H43)
))/EXP(D41*D42/D43)