Binomial Trees

Chapter 11

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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

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 A Call Option (Figure 11.1, page 238)

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

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 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

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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

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 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 )

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Generalization (Figure 11.2, page 239)

A derivative lasts for time T and is

dependent on a stock

S0u
ƒu
S0
ƒ S0d
ƒd
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Generalization
(continued)
 Consider the portfolio that is long  shares and
short 1 derivative

S0u– ƒu

S0d– ƒd
 The portfolio is riskless when S0u– ƒu = S0d– ƒd
or
ƒu  f d

S 0u  S 0 d
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Generalization
(continued)

Value of the portfolio at time T is

S0u– ƒu
Value of the portfolio today is
(S0u – ƒu)e–rT
Another expression for the portfolio
value today is S0– f
Hence
ƒ = S0– (S0u– ƒu )e–rT

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 Generalization
(continued)

Substituting for  we obtain

ƒ = [ pƒu + (1 – p)ƒd ]e–rT

where

e drT
p
ud
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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
p ƒu
S0
ƒ S0d
(1–
p) ƒd
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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

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Original Example Revisited
S0u = 22
p ƒu = 1
S0
ƒ
(1– S0d = 18
p) ƒd = 0
 Since p is the probability that gives a return on the
stock equal to the risk-free rate. We can find it from
20e0.12 0.25 = 22p + 18(1 – p )
which gives p = 0.6523
 Alternatively, we can use the formula
e rT  d e 0.120.25  0.9
p   0.6523
ud 1. 1  0. 9
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 Valuing the Option Using Risk-
Neutral Valuation
S0u = 22
523 ƒu = 1
0. 6
S0
ƒ
0.34 S0d = 18
77
ƒd = 0

The value of the option is

e–0.120.25 (0.65231 + 0.34770)
= 0.633
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Irrelevance of Stock’s Expected
Return

 When we are valuing an option in terms

of the price of the underlying asset, the
probability of up and down movements in
the real world are irrelevant
 This is an example of a more general
result stating that the expected return on
the underlying asset in the real world is
irrelevant
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A Two-Step Example
Figure 11.3, page 242

24.2
22

20 19.8

18
16.2
Each time step is 3 months
K=21, r=12%

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Valuing a Call Option
Figure 11.4, page 243
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 is
e–0.120.25(0.65233.2 + 0.34770) = 2.0257
 Value at node A is

e–0.120.25(0.65232.0257 + 0.34770) = 1.2823

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 A Put Option Example
Figure 11.7, page 246

K = 52, time step =1yr

r = 5% 72
D
0
60
B
50 1.4147 48
A E
4.1923 4
40
C
9.4636 32
F 20

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What Happens When an Option
is American (Figure 11.8, page 247)

72
D
0
60
B
50 1.4147 48
A E
5.0894 4
40
C
12.0 32
F 20

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 Delta
Delta () 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  varies from node to node

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

u  e t

d  1 u  e  t

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

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

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The Probability of an Up Move

ad
p
ud

 a  e rt for a nondividen d paying stock

 a  e ( r  q ) t for a stock index wher e q is the dividend
yield on the index
( r  r f ) t
a  e for a currency where rf is the foreign
risk - free rate
 a  1 for a futures contract

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