Introduction to Binomial

Trees

Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 11.1
 A Simple Binomial Model

 A stock price is currently $20

 In three months it will be either $22 or $18

Stock Price = $22

Stock price = $20

Stock Price = $18

Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 11.2
A Call Option (Figure 11.1, page 248)

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

21.

Stock Price = $22

Option Price = $1
Stock price = $20
Option Price=?
Stock Price = $18
Option Price = $0
 Setting Up a Riskless Portfolio
 Consider the Portfolio: long  shares short 1 call option

 Portfolio is riskless when 22– 1 = 18 or

 = 0.25 22– 1

18

Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 11.4
 Valuing the Portfolio
(Risk-Free Rate is 12%)

 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 – 0.120.25 = 4.3670

Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007
 Valuing the Option
 The portfolio that is
long 0.25 shares
short 1 option
is worth 4.367
 The value of the shares is
5.000 (= 0.25 20 )
 The value of the option is therefore
0.633 (= 5.000 – 4.367 )
Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 11.6
 Generalization (Figure 11.2, page 249)

A derivative lasts for time T and is

dependent on a stock

S(1+a)=Su
ƒu
S
ƒ S(1-a)=Sd
ƒd
Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 11.7
 Generalization
(continued)

 Consider the portfolio that is long  shares and short 1

derivative
Su– ƒu

Sd– ƒd
 The portfolio is riskless when Su– ƒu = Sd – ƒd or

ƒu  f d

Su  S d
Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 11.8
 Generalization
(continued)
 Value of the portfolio at time T is
Su – ƒu
 Value of the portfolio today is
(Su  – ƒu )e–rT
 Another expression for the
portfolio value today is S – f
 Hence ƒ = S – (Su – ƒu )e–rT

Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 11.9
 Generalization
(continued)

 Substituting for  we obtain

ƒ = [ p ƒu + (1 – p )ƒd ]e–rT

where

e rT
1 a
p
2a
Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 11.10
 Risk-Neutral Valuation

 ƒ = [ p ƒu + (1 – p )ƒd ]e-rT
 The variables p and (1– p ) can be interpreted as the
risk-neutral probabilities of up and down movements
 The value of a derivative is its expected payoff in a
risk-neutral world discounted at the risk-free rate

Su
p ƒu
S
ƒ Sd
(1–
p) ƒd
Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 11.11
 Original Example Revisited
Su = 22
p ƒu = 1
S
ƒ
(1– Sd = 18
p) ƒd = 0
 Since p is a risk-neutral probability 20e0.12
0.25 = 22p + 18(1 – p ); p = 0.6523

Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 11.12
 Valuing the Option

Su = 22
52 3 ƒu = 1
0. 6
S
ƒ
0.34 Sd = 18
77
ƒd = 0
The value of the option is
e–0.120.25 [0.65231 + 0.34770]
= 0.633

Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 11.13
 Estimating p
One way of matching the volatility is to set
e rT  1  a
p
2a
a  e t
1

where  is the volatility andt is the length

of the time step. This is the approach used
by Cox, Ross, and Rubinstein

Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 11.14
 A Two-Step Example
Figure 11.3, page 253

24.2
22

20 19.8

18
16.2
 Each time step is 3 months
 K=21, r=12%
Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 11.15
 Valuing a Call Option
Figure 11.4, page 253
24.2
D
3.2
22
B
20 2.0257 19.8
A E
1.2823 0.0
18
C
0.0 16.2
F 0.0
 Value at node B
= e–0.120.25(0.65233.2 + 0.34770) = 2.0257
 Value at node A
= e–0.120.25(0.65232.0257 + 0.34770)
= 1.2823

Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 11.16
 A Put Option Example; K=52
Figure 11.7, page 256

K = 52, t = 1yr
r = 5% 72
D
0
60
B
50 1.4147 48
A E
4.1923 4
40
C
9.4636 32
F 20

Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 11.17