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**Derive Black-Scholes Option Pricing Model
**

1

CHENG-FEW LEE

Department of Finance and Economics, Rutgers Business School

Rutgers University, New Brunswick

New Jersey, U.S.

CARL S. LIN

Department of Economics

Rutger University, New Brunswick

New Jersey, U.S.

Abstract

In this chapter, we review two famous models on binomial option pricing, Rendleman and

Barter (RB, 1979) and Cox, Ross, and Rubinstein (CRR, 1979). We show that the limiting

results of the two models both lead to the celebrated Black-Scholes formula. From our

detailed derivations, CRR is easy to follow if one has the advanced level knowledge in

probability theory but the assumptions on the model parameters make its applications limited.

On the other hand, RB model is intuitive and does not require higher level knowledge in

probability theory. Nevertheless, the derivations of RB model are more complicated and

tedious. For readers who are interested in the binomial option pricing model, they can

compare the two different approaches and find the best one which fits their interests and is

easier to follow.

1. Introduction

The main purpose of this chapter is to review two famous binomial option pricing

model: Rendleman and Barter (RB, 1979) and Cox, Ross, and Rubinstein (CRR, 1979).

First, we will give an alternative detailed derivation of the two models and show that

the limiting results of the two models both lead to the celebrated Black-Scholes

1

Section 3 of this chapter is essentially drawing from the paper by Lee et al.(2004).

1

formula. Then we will make comparisons of the two different approaches and analyze

the advantages of each approach.

Hence, this chapter can help to understand the statistical aspects of option pricing

models for Economics and Finance professions. Also, it gives important financial and

economic intuitions for readers in statistics professions. Therefore, by showing two

alternative binomial option pricing models approaches to derive the Black-Scholes

model, this chapter is useful for understanding the relationship between the two

important optional pricing models and the Black-Scholes formula.

2. The Two-State Option Pricing Model of Rendleman and Bartter

In Rendleman and Bartter (1979), a stock price can either advance or decline during the

next period. Let

T

H

+

and

T

H

−

represent the returns per dollar invested in the stock if the

price rises (the + state) or falls (the - state), respectively, from time T-1 to time T. And

T

V

+

and

T

V

−

the corresponding end-of-period values of the option.

Let R be the riskless interest rate, Rendleman and Bartter (1979) show that the price

of the option can be represented as a recursive form

2

1

(1 ) ( 1 )

( )(1 )

T T T

T

T T

V R H V H R

P

H H R

+ − − +

−

− + −

+ − + − −

·

− +

that can be applied at any time T-1 to determine the price of the option as a function of

its value at time T.

2.1 The Discrete Time Model

From the above equation, the value of a call option at maturing date T-1 is given by

1

(1 ) ( (1 ))

( )(1 )

T T

T

W R H W H R

W

H H R

+ − − +

− + −

+ − + − +

·

− +

(2.1)

Similarly,

1 1

2

(1 ) ( (1 ))

( )(1 )

T T

T

W R H W H R

W

H H R

+ − − +

− −

− + −

+ − + − +

·

− +

(2.2)

Substituting (2.1) into (2.2) can get,

2 2 2

( (1 ) ( (1 )))(1 )

( ) (1 )

T T

T

W R H W H R R H

W

H H R

++ − +− + −

− + −

+ − + − + + −

·

− +

2 2

( (1 ) ( (1 )))( (1 ))

( ) (1 )

T T

W R H W H R H R

H H R

−+ − −− + +

+ −

+ − + − + + +

+

− +

(2.3)

Noting that

T T

W W

+− −+

· , so (2.3) can be simplified as:

2 2

2 2 2

( (1 ) 2 ( (1 )))(1 ) ( (1 ))

( ) (1 )

T T T

T

W R H W H R R H W H R

W

H H R

++ − +− + − −− +

− + −

+ − + − + + − + − +

·

− +

(2.4)

3

We can use this recursive form to get

0

W

:

Since after T periods, there are

0

T ¸ _

¸ ,

ways that a sequence of (T) pluses can occur,

1

T ¸ _

¸ ,

ways that (T-1) pluses can occur,

2

T ¸ _

¸ ,

ways that (T-2) pluses can occur, and so

on….

Hence, by Binomial Theorem

0

W

can be represented as:

0

W ·

...... 0

...... 1 1

..... 2 2

.... 1 1

...... 0

[ (1 ) ( (1 ))

0

(1 ) ( (1 ))

1

(1 ) ( (1 ))

2

(1 ) ( (1 ))

1

(1 ) ( (1

T

T

T

T

T

T

T

T

T

T

W R H H R

T

W R H H R

T

W R H H R

T

W R H H R

T

T

W R H H

T

+ + − +

+ − − − +

+ −− − − +

+−− − − + −

− − − +

¸ _

+ − − +

¸ ,

¸ _

+ + − − +

¸ ,

¸ _

+ + − − +

¸ ,

¸ _

+ + − − +

−

¸ ,

¸ _

+ + − − +

¸ ,

M

)) ]

[( )(1 )]

T

T

R

H H R

+ −

− +

(2.5)

Next to determine the value of the option at maturity. Suppose that stock increases i

times and declines

( ) T i −

times, then the price of the stock will be

0

i T i

S H H

−

+ −

on the

expiration date. So the option will be exercised if

4

0

i T i

S H H X

−

+ −

>

The maturity value of the option will be

0

i T i

T

W S H H X

−

+ −

· − (2.6)

Let

a

denote the minimum integer value of i in (2.6) for which the inequality is

satisfied.

0

ln( ) ln( )

1

ln ln

X

T H

S

a INT

H H

−

+ −

1

−

1

· +

1

−

1

¸ ]

(2.7)

where

[ ] INT ⋅

is the integer operator.

i.e., taking natural logarithm of RHS of (2.6),

0

0

0

ln ln ( ) ln ln

ln ln ln( ) ln

ln( ) ln

ln ln

S i H T i H X

X

i H i H T H

S

X

T H

S

i

H H

+ −

+ − −

−

+ −

+ + − ·

⇒ − · −

−

⇒ ·

−

Hence, the maturing value of the option is given by

0

0

i T i

T

T

W S H H X if i a

W if i a

−

+ −

· − ≥

· <

K K

K K

(2.8)

Substituting (2.8) into (2.5), then the generalized option pricing equation for the

5

discrete time is

0

0

( )(1 ) ( (1 ))

( ) (1 )

i T i

T

i T i

i a

T T

T

S H H X R H H R

i

W

H H R

−

+ − − + −

·

+ −

¸ _

− + − − +

¸ ,

·

− +

∑

(2.9)

2.2 The Continuous Time Model

For (2.9), we can write is as:

0

0

0

( )(1 ) ( (1 )) (1 ) ( (1 ))

( ) (1 )

[ (1 )] [ ( 1 )]

( ) (1 )

(1 ) ( (1 ))

(

i T i

T T

i T i i T i

i a i a

T T

T

i T i

i a

T T

T

i T i

i a

T T

S H H R H H R X R H H R

i i

W

H H R

T

S H R H H H R

i

H H R

T

X R H H R

i

H

−

+ − − + − − + −

· ·

+ −

+ − − + −

·

+ −

− + −

·

+

¸ _ ¸ _

+ − − + − + − − +

¸ , ¸ ,

·

− +

¸ _

+ − − −

¸ ,

·

− +

¸ _

+ − − +

¸ ,

−

−

∑ ∑

∑

∑

0

) (1 )

(1 ) ( 1 )

(1 )( ) ( )(1 )

(1 ) ( 1 )

(1 ) ( ) ( )

T T

i T i

T

i a

i T i

T

T

i a

H R

T

R H H H R H

S

i R H H H H R

T

X R H H R

i R H H H H

−

−

− + + −

+ − + −

·

−

− +

+ − + −

·

+

1 1 ¸ _ + − − −

·

1 1

+ − − +

¸ , ¸ ] ¸ ]

1 1 ¸ _ + − − −

−

1 1

+ − −

¸ , ¸ ] ¸ ]

∑

∑

(2.10)

Since

(1 )

(1 )( )

R H H

R H H

− +

+ −

+ −

+ −

+

( 1 )

1

( )(1 )

H R H

H H R

+ −

+ −

− −

·

− +

,

(1 ) ( 1 )

1

( ) ( )

R H H R

H H H H

− +

+ − + −

+ − − −

+ ·

− −

,

therefore, can interpret it as “pseudo probability”.

Let

(1 )

(1 )( )

R H H

R H H

ϕ

− +

+ −

+ −

·

+ −

and

(1 )

( )

R H

H H

φ

−

+ −

+ −

·

−

, we can restate (2.10) as:

6

0 0

( , , ) ( , , )

(1 )

T

X

W S B a T B a T

R

ϕ φ · −

+

(2.11)

where

( , , ( )) B a T ⋅

is the cumulative binomial probability function, the number of

successes will fall between

a

and T after T trials.

As T →∞ ,

0 0 1 1 2 2

( , ) ( , )

(1 )

T

X

W S N Z Z N Z Z

R

′ ′ −

+

:

(2.12)

where

( , ) N Z Z′

is the probability of a normally distributed random variable with zero

mean and variance 1 taking values between a lower limit Z and a upper limit Z′ . And

by the property of binomial pdf,

1 1

2 2

,

(1 ) (1 )

,

(1 ) (1 )

a T T T

Z Z

T T

a T T T

Z Z

T T

ϕ ϕ

ϕ ϕ ϕ ϕ

φ φ

φ φ φ φ

− −

′ · ·

− −

− −

′ · ·

− −

Thus,

0 0 1 1 2 2

(lim , lim ) (lim , lim )

lim(1 )

T

T T T T

T

X

W S Z Z N Z Z

R

→∞ →∞ →∞ →∞

→∞

′ ′ · −

+

(2.13)

Let

1

r

T

R e + ·

, then

lim(1 )

T r

T

R e

→∞

+ ·

. And since 1 2

lim lim

T T

Z Z

→∞ →∞

′ ′ · · ∞

, the remaining

things to be determined are 1

lim

T

Z

→∞

and 2

lim

T

Z

→∞

.

From equation (10) and (11) of the text in the Rendleman and Bartter (1979),

7

(1 )

( )

( )

(1 )

T

T

T

T

H e

H e

θ

µ

σ

θ

θ

µ

σ

θ

−

+

+

−

− −

·

·

substituting

H

+

and

H

−

into (2.7), so

0

1

ln( )

1

1

(1 )

(1 ) (1 )

X

T

S

INT T

T

a T

Z

T T

θ

µ σ

θ

ϕ

σ

θ θ

ϕ

ϕ ϕ ϕ ϕ

1

− +

1

−

1

+ −

1

1

−

−

¸ ]

· ·

− −

In the limit, the term

1 [ ] INT + ⋅

will be simplify to

[ ] ⋅

. So,

0

1

0

0

0

ln( )

1 1

1

(1 ) (1 )

(1 ) (1 )

ln( )

1

1

(1 ) (1 ) (1 )

(1 )

(1 )

ln( )

1

(1 ) (1 ) (1 )

(1 )

(1 )

ln( )

(1 )

1

(1 )

(1 )

X

T

S

Z

T T

T T

X

T

S T

T T

T

X

T

S T

T T

T

X

T T

S

T

θ

µ

σ

θ

σ σ

ϕ ϕ ϕ ϕ

θ θ θ θ

θ

µ

σ

ϕ

θ

σ

ϕ ϕ ϕ ϕ ϕ ϕ

σ

θ θ

θ θ

θ

µ

σ

ϕ

θ

ϕ ϕ σ ϕ ϕ ϕ ϕ

σ

θ θ

θ θ

θ

µ

θ θ

θ

ϕ ϕ ϕ

σ

θ θ

−

−

+

− −

− −

−

−

+ −

− − −

−

−

−

−

+ −

− − −

−

−

−

−

−

+

−

−

:

:

:

:

0

(1 ) (1 )

ln( )

( )

(1 ) (1 )

(1 )

T

T

X

S T

ϕ

ϕ ϕ ϕ

µ

θ ϕ

ϕ ϕ ϕ ϕ

σ

θ θ

−

− −

−

−

+

− −

−

:

(2.14)

8

Substituting

H

+

,

H

−

and

1

r

T

R e + ·

into

ϕ

,

1

( ) ( )

1

1

( ) ( )

1

1

( ) ( )

1

1

( ) ( )

1

1 1

( ) ( ) ( )

1

(1 )

(1 )( )

r

T T T T T

r

T T T T T

r

T T T T

r

T T

T

r

T T T T T

R H H

R H H

e e e

e e e

e e e

e e e

e e

µ θ µ θ

σ σ

θ θ

µ θ µ θ

σ σ

θ θ

µ θ θ

σ σ

θ θ

θ θ

σ σ

θ θ

θ µ θ θ

σ σ σ

θ θ θ

ϕ

− +

+ −

−

− +

−

−

+ −

−

−

−

−

−

−

− −

− − +

−

+ −

·

+ −

1

− 1

1

¸ ]

·

1

− 1

1

¸ ]

1

− 1

1

¸ ]

·

1

− 1

1

¸ ]

−

¸

·

1

( ) ( )

1

1 1

( ) ( )( )

1

1 1

( ) ( ) ( ) ( )

1 1

T T

r

T T T T

T T T T

e e

e e

e e e e

θ θ

σ σ

θ θ

θ µ θ θ

σ σ

θ θ θ

θ θ θ θ

σ σ σ σ

θ θ θ θ

−

−

− −

− + −

−

− −

− −

1

1

1

]

1

− 1

1

¸ ]

1 1

1 1

1 1

¸ ] ¸ ]

· −

1 1

− − 1 1

1 1

¸ ] ¸ ]

Now expanding in Taylor’s series in T,

9

2 2

2 2

2

1

( )

1

1 1 1 1

( ) ( ) ( )

1 2 1

1 1

( ) ( )

2 1

1 1 1 1

( ) ( ) ( )

1 2 1

1

( )

1

2 1

1 1 1 1

( ) ( )( ) ( )

1 2 1

1

1 1

( ) ( )(

1 2

T o

T

T o

T T

r O

T

T o

T T

r

T

o

T T

T

θ

σ

θ

θ θ σ θ θ

σ

θ θ θ θ

θ

µ σ σ

θ

θ θ σ θ θ

σ

θ θ θ θ

θ

µ σ σ

θ

θ θ σ θ θ

σ

θ θ θ θ

θ

θ

θ θ σ

θ θ

+

−

·

1

− −

+ + − +

1

− −

¸ ]

− − + +

−

+

1

− −

+ + − +

1

− −

¸ ]

− − +

−

·

− −

+ + − +

− −

−

+

−

+ +

−

1

( )

1 1

) ( )

1

o

T

o

T

θ θ

θ θ

+

1

−

− +

1

−

¸ ]

where,

2

3

2

1 1 1

1

2!

1 1

3!

1 1 1

1

2

H

T T

T T

T T

o

T T T T

µ σ θ µ σ θ

θ θ

µ σ θ

θ

µ σ θ σ θ

θ θ

+

¸ _ ¸ _

− −

· + + + +

¸ , ¸ ,

¸ _

−

+ + +

¸ ,

− −

¸ _ ¸ _

· + + + +

¸ , ¸ ,

L

and

2

3

2

1

1

1 2! 1

1

3! 1

1

1

1 2 1

H

T T

T T

T T

o

T T T T

µ σ θ µ σ θ

θ θ

µ σ θ

θ

µ σ θ σ θ

θ θ

−

¸ _ ¸ _

· + − + −

− −

¸ , ¸ ,

¸ _

+ − +

−

¸ ,

¸ _ ¸ _

· + + + +

− −

¸ , ¸ ,

L

10

where

1

( ) o

T

denotes a function tending to zero more rapidly than

1

T

.(when we

expanding in Taylor’s series in T, the rest of the terms tending to zero more rapidly than

1

T

so regard them as a function

1

( ) o

T

.) Hence,

2

1 1

lim (1 )

1

1

1

(1 )

1

T

θ θ

θ

θ θ

ϕ θ θ

θ θ

θ

θ θ

θ θ

θ θ

θ

θ

→∞

− −

· · · −

− +

−

−

+

−

−

·

·

and,

11

2 2

2

2 2

2

lim ( )

1

( )

1

2 1

lim [

1 1 1 1

( ) ( )( ) ( )

1 2 1

1

1

( )]

1 1 1 1

( ) ( )( ) ( )

1 2 1

1

( )

2 1

lim[

1 1 1 1

( ) ( )( ) ( )

1 2 1

T

T

T

T

r

T

T

o

T T

o

T

o

T T

r

T

o

T

T

T

θ ϕ

θ

µ σ σ

θ

θ

θ θ σ θ θ

σ

θ θ θ θ

θ

θ

θ θ σ θ θ

θ θ θ θ

θ

µ σ σ

θ

θ

θ θ σ θ θ

σ

θ θ θ θ

θ

→∞

→∞

→∞

−

− − +

−

· −

− −

+ + − +

− −

−

− −

1

− −

+ + − +

1

− −

¸ ]

− − +

−

· −

− −

+ + − +

− −

−

2

2

2 2

2

1

1

( )]

1 1 1 1

( ) ( )( ) ( )

1 2 1

1 1 1 1

( ) ( )( ) ( )

1 2 1 1

lim

1 1 1 1

( ) ( )( ) ( )

1 2 1

1

( )

2 1

1 1 1

( ) ( )( ) (

1 2 1

T

To

T

o

T

T

T o T

T T

o

T T

r

o

T

θ

θ θ σ θ θ

θ θ θ θ

θ θ σ θ θ θ

σ θ

θ θ θ θ θ

θ θ σ θ θ

σ σ

θ θ θ θ

θ

µ σ σ

θ

θ θ σ θ θ

σ

θ θ θ θ

→∞

−

−

1

− −

+ + − +

1

− −

¸ ]

1

− −

+ + − + −

1

− − −

¸ ]

·

− −

+ + − +

− −

− − +

−

−

− −

+ + − +

− −

2 2 2

2 2

2 2 2

2 2 2

2 2 2 2

1

( )

1

)

1 1 1

( ) ( ( ) )

2 1 2 1

1

( )

1

1 (1 ) 1

( ) ( )

2 (1 ) 2 1

1

(1 )

1 1 2 1

( ) ( )

2 1 2 1

1

(1 )

1 1 1 1

( ) ( ) ( )

2 1 2 1 2 1

1

(1 )

To

T

T

r

r

r

r

θ θ θ

θσ µ σ σ

θ θ θ

θ θ

σ

θ θ

θ θ θ

θσ µ σ σ

θ θ θ

σ

θ θ

θ θ

σ µ σ σ

θ θ

σ

θ θ

θ θ θ

σ σ µ σ σ

θ θ θ

σ

θ θ

−

−

− − − − +

− −

·

−

+

−

− −

− + + −

− −

·

−

−

− + + −

− −

·

−

−

− − + + −

− − −

·

−

12

After canceling terms,

2

1

(1 )( )

2

lim ( )

T

r

T

θ θ µ σ

θ ϕ

σ

→∞

− − − +

− ·

Now substituting

lim

T

ϕ

→∞

for

ϕ

and

lim ( )

T

T θ ϕ

→∞

−

for ( ) T θ ϕ − into (2.14),

2

0

1

2

0

1

ln( )

(1 )( )

2

lim

(1 ) (1 )

(1 )

1

ln( )

2

T

X

r

S

Z

X

r

S

µ

θ θ µ σ

θ θ σ θ θ

σ

θ θ

σ

σ

→∞

−

− − +

· −

− −

−

− −

·

Similarly,

2

0

2

1

ln( )

2

lim

T

X

r

S

Z

σ

σ

→∞

− +

·

Since

( , ) ( , ) N Z N Z ∞ · −∞ −

, let 1 1

lim

T

D Z

→∞

· −

, 2 2

lim

T

D Z

→∞

· −

, the continuous time

version of the two-state model is obtained:

0 0 1 2

2

0

1

2 1

( , ) ( , )

1

ln( )

2

r

w S N D Xe N D

X

r

S

D

D D

σ

σ

σ

−

· −∞ − −∞

+ +

·

· −

The above equation is identical to the Black-Scholes model.

13

3. The Binomial Option Pricing Model of Cox, Ross and Rubinstein

In this section we will concentrate on the limiting behavior of the binomial option

pricing model proposed by Cox, Ross and Rubinstein (CRR, 1979).

3.1 The Binomial Option Pricing Formula of CRR

Let S be the current stock price, K the option exercise price, 1 − R the riskless rate. It

is assumed that the stock follows a binomial process, from one period to the next it can

only go up by a factor of

u

with probability

p

or go down by a factor of d with

probability

) 1 ( p −

. After n periods to maturity, CRR showed that the option price C is:

. ] , 0 [ ) 1 (

)! ( !

! 1

0

∑

·

− −

− −

−

·

n

k

k n k k n k

n

K S d u Max p p

k n k

n

R

C

(3.1)

An alternative expression for C, which is easier to evaluate, is

). , ; ( ) , ; (

] ) 1 (

)! ( !

!

[ ] ) 1 (

)! ( !

!

[

p n m B

R

K

p n m SB

p p

k n k

n

R

K

R

d u

p p

k n k

n

S C

n

n

m k

k n k

n

n

m k

k n k

k n k

− ′ ·

−

−

− −

−

·

∑ ∑

·

−

·

−

−

(3.2)

where

) 1 ( ) , ; (

∑

·

−

− ·

n

m k

k n k

k n

p p C p n m B

and m is the minimum number of upward

stock movements necessary for the option to terminate in the money, i.e., m is the

14

minimum value of k in (3.1) such that 0. X - S d

m - n m

> u

3.2 Limiting Case

We now show that the binomial option pricing formula as given in Equation (3.2) will

converge to the celebrated Black-Scholes option pricing model. The Black-Scholes

formula is

) ( ) (

1 1

t d N X e d N S C

rt

σ − − ·

−

(3.3)

where

2

) log(

1

t

t

XR

S

d

t

σ

σ

+ ·

−

(3.4)

2

σ = the variance of stock rate of return

t = the fixed length of calendar time to expiration date, such that

n

t

h · .

We wish to show that Equation (3.2) will coincide with Equation (3.3) when

∞ → n

.

In order to show the limiting result that the binomial option pricing formula

converges to the continuous version of Black-Scholes option pricing formula, we

suppose that h represents the lapsed time between successive stock price changes.

Thus, if t is the fixed length of calendar time to expiration, and n is the total number of

15

periods each with length h, then

n

t

h · . As the trading frequency increases, h will get

closer to zero. When 0 → h , this is equivalent to

∞ → n

.

Let

R

ˆ be one plus the interest rate over a trading period of length h. Then, we will

have

t T

R R ·

ˆ (3.5)

for any choice of n. Thus,

n

t

R R ·

ˆ

, which shows that

R

ˆ must depend on n for the total

return over elapsed time t to be independent of n. Also, in the limit,

n

r

−

+ ) 1 ( tends to

rt

e

−

as

∞ → n

.

Let S

*

be the stock price at the end of the nth period with the initial price S. If there

are j up periods, then

d n

d

u

j d j n u j

S

S

log ) log( log ) ( log log

*

+ · − + · (3.6)

where j is the number of upward moves during the n periods.

Since j is the realization of a binomial random variable with probability of a success

being q, we have expectation of log (S

*

/S)

, ˆ ] log ) log( [ ) (log

*

n n d

d

u

q

S

S

E µ · + · (3.7)

and its variance

16

. ˆ ) 1 ( )] [log( ) (log

2 2

*

n n q q

d

u

S

S

Var σ · − · (3.8)

Since we divide up our original longer time period t into many shorter subperiods of

length h so that hn t · , our procedure calls for making n longer, while keeping the

length t fixed. In the limiting process we would want the mean and the variance of the

continuously compounded log rate of return of the assumed stock price movement to

coincide with that of actual stock price as

∞ → n

. Let the actual values of

n µˆ

and

n

2

ˆ σ respectively. Then we want to choose u, d, and q in such a manner that

t n µ µ → ˆ

and t n

2 2

ˆ σ σ → as

∞ → n

. It can be shown that if we set

,

n

t

e u

σ

·

,

n

t

e d

σ −

·

(3.9)

,

2

1

2

1

n

t

q

,

_

¸

¸

+ ·

σ

µ

then

t n µ µ → ˆ

and t n

2 2

ˆ σ σ → as

∞ → n

. In order to proceed further, we need the

following version of the central limit theorem.

Lyapounov’s Condition. Suppose , ,

2 1

X X are independent and uniformly bounded

with

0 ) ( ·

i

X E

,

,

1 n n

X X Y + + ·

and ). ( ) (

2 2

n n

Y Var Y E s · ·

17

If

0

1

lim

1

2

2

·

∑

·

+

+

∞ →

n

k

k

n

n

X E

s

δ

δ

for some

, 0 > δ

then the distribution of

n

n

s

Y

converges to

the standard normal as

∞ → n

.

Theorem 1. If

3 3

3

ˆ ˆ log (1 ) log

0 as

ˆ

p u p d

n

n

µ µ

σ

− + − −

→ →∞ (3.10)

then

) (

ˆ

ˆ ) log(

Pr

*

z N z

n

n

S

S

→

1

1

1

1

]

1

¸

≤

−

σ

µ

(3.11)

where N(z) is the cumulative standard normal distribution function.

Proof. See Appendix.

It is noted that the condition (3.10) is a special case of the Lyapounov’s condition

which is stated as follows. When

, 1 · δ

we have the condition (3.10).

This theorem says that when the fixed length t is divided into many subperiods, the

log rate of return will approach to the normal distribution when the number of

subperiods approached infinity. For this theorem to hold, the condition stated in

Equation (3.10) has to be satisfied. We next show that this condition is indeed satisfied.

We will next show that the binomial option pricing model as given in Equation (3.2)

18

will indeed coincide with the Black-Scholes option pricing formula as given in

Equation (3.3). Observe that

n

R

−

ˆ

is always equal to

t

R

−

, as evidenced from Equation

(3.5). Thus, comparing the two option pricing formulae given in Equations (3.2) and

(3.3), we see that there are apparent similarities. In order to show the limiting result,

we need to show that as

∞ → n

,

) ( ) , ; ( x N p n m B → ′

and ). ( ) , ; ( t x N p n m B σ − →

In this section we will only show the second convergence result, as the same

argument will hold true for the first convergence. From the definition of

) , ( pm n B

, it is

clear that

).

) 1 (

1

) 1 (

Pr(

) 1 Pr( ) , ; ( 1

p np

np m

p np

np j

m j p n m B

−

− −

≤

−

−

·

− ≤ · −

(3.12)

Recall that we consider a stock to move from S to uS with probability p and dS with

probability (1-p). During the fixed calendar period of t=nh with n subperiods of length

h, if there are j up moves, then

d n

d

u

j

S

S

log ) log( log

*

+ · . (3.13)

The mean and variance of the continuously compounded rate of return for this stock

are

P

µˆ

and

2

ˆ

P

σ where

19

d

d

u

p

P

log ) log( ˆ + · µ and ) 1 ( )] [log( ˆ

2 2

p p

d

u

P

− · σ .

From Equation (3.13) and the definitions for

P

µˆ

and

2

ˆ

P

σ , we have

n

n

S

S

p np

np j

P

P

σ

µ

ˆ

ˆ ) log(

) 1 (

*

−

·

−

−

. (3.14)

Also, from the binomial option pricing formula we have

, log / ] log [log

) log(

) log(

1

ε

ε

− − ·

− · −

d

u

d n

S

X

d

u

Sd

X

m

n

where is a real number between 0 and 1.

From the definitions of

P

µˆ

and

2

ˆ

P

σ , it is easy to show that

.

ˆ

) log( ˆ ) log(

) 1 (

1

n

d

u

n

S

X

p np

np m

P

P

σ

ε µ − −

·

−

− −

Thus from Equation (3.12) we have

).

ˆ

) log( ˆ log

ˆ

ˆ log

Pr( ) , ; ( 1

*

n

d

u

n

S

X

n

n

S

S

p n m B

P

P

P

P

σ

ε µ

σ

µ − −

≤

−

· −

(3.15)

20

We will now check the condition given by Equation (3.10) in order to apply the

central limit theorem. Now recall that

d u

d r

p

−

−

·

ˆ

,

with

n

t

r r · ˆ

, and d and u are given in Equation (3.9).

We have

log

3

2

2

3

2

2

1

1

1 log [1 ] ( )

2

1 [1 ] ( )

1

log

1 1

2

[ ] ( ). (3.16)

2 2

t t

r

n n

t t

n n

e e

p

e e

t t t

r O n

n n n

t t

O n

n n

r

t

O n

n

σ

σ σ

σ σ

σ σ

σ

σ

−

−

−

−

−

−

·

−

+ − − + +

·

+ − − +

−

· + +

Hence, the condition given by Equation (10) is satisfied because

. as , 0

) 1 (

) 1 (

ˆ

| ˆ log | ) 1 ( | ˆ log |

2 2

3

3 3

∞ → →

−

+ −

·

− − + −

n

p np

p p

n

d p u p

p

p p

σ

µ µ

Finally, in order to apply the central limit theorem, we have to evaluate

n

p

µˆ

,

n

p

2

ˆ σ

and ) log(

d

u

as

. ∞ → n

It is clear that

21

t n t r n

p p

2 2 2

ˆ , )

2

1

(log ˆ σ σ σ µ → − → and 0 ) log( →

d

u

.

Hence, in order to evaluate the asymptotic probability in Equation (3.12), we have

.

)

2

1

(log ) log(

ˆ

) log( ˆ ) log(

2

t

t r

S

X

z

n

d

u

n

S

X

p

p

σ

σ

σ

ε µ − −

· →

− −

Using the fact that

) ( ) ( 1 z N z N − · −

, we have, as

∞ → n

). ( ) ( ) , ; ( t x N z N p n m B σ − · − →

Similar argument holds for

) ' , ; ( p n m B

, and hence we completed the proof that the

binomial option pricing formula as given in equation (3.2) includes the Block-Scholes

option pricing formula as a limiting case.

4. Comparison of the Two Approaches

From the results of last two sections, we show that both RB and CRR models lead to

the celebrated Black-Scholes formula. The following table shows the comparisons of

the necessary mathematical and statistical knowledge and assumptions for the two

models.

Model Rendleman and Bartter (1979) Cox, Ross and Rubinstein (1979)

22

Mathematical

and

Probability

Theory

Knowledge

Basic Algebra

Taylor Expansion

Binomial Theorem

Central Limit Theorem

Properties of Binomial Distribution

Basic Algebra

Taylor Expansion

Binomial Theorem

Central Limit Theorem

Properties of Binomial Distribution

Lyapounov’s Condition

Assumption 1. The distribution of returns of the

stock is stationary over time and the

stock pays no dividends.(Discrete

Time Model)

2. The mean and variance of

logarithmic returns of the stock are

held constant over the life of the

option.(Continuous Time Model)

The stock follows a binomial process

from one period to the next it can

only go up by a factor of “u” with

probability “p” or go down by a

factor of “d” with probability “1-p”.

In order to apply the Central Limit

Theorem, “u”, “d”, and “p” are

needed to be chosen.

Advantage

and

Disadvantage

1. Readers who have undergraduate

level training in mathematics and

probability theory can follow this

approach.

2. The approach of RB is intuitive.

But the derivation is more

complicated and tedious than the

approach of CRR.

1. Readers who have advanced level

knowledge in probability theory can

follow this approach; but for those

who don’t, CRR approach may be

difficult to follow.

2. The assumption on the parameters

“u”, “d”, “p” makes CRR approach

more restricted than RB approach.

Hence, like we indicate in the table, CRR is easy to follow if one has the advanced

level knowledge in probability theory but the assumptions on the model parameters

make its applications limited. On the other hand, RB model is intuitive and does not

require higher level knowledge in probability theory. However, the derivation is more

complicated and tedious.

For readers who are interested in the binomial option pricing model, they can

compare the two different approaches and find the best one which fits their interests and

is easier to follow.

23

Appendix

The Binomial Theorem

0

( )

n

n k n k

k

n

x y x y

k

−

·

¸ _

+ ·

¸ ,

∑

Lindberg-Levy Central Limit Theorem

If

1

,...,

n

x x

are a random sample from a probability distribution with finite mean

µ

and

finite variance

2

σ and

1

1

( )

n

i

i

x x

n

·

·

∑

, then

2

( ) 0,

d

n

n x N µ σ 1 − ÷÷→

¸ ]

Proof of Theorem 1.

Since

3 3

3

3

ˆ log log log log (1 ) log

u u

p u p u p d p p

d d

µ − · − − · −

And

3 3

3

3

ˆ (1 ) log (1 ) log log log (1 ) log ,

u u

p d p d p d p p

d d

µ − − · − − − · −

24

We have

3

3 3

2 2

ˆ ˆ log (1 ) log (1 )[(1 ) ] log

u

p u p d p p p p

d

µ µ − + − − · − − − .

Thus

3 3

3

3

2 2

3

2 2

ˆ ˆ log (1 ) log

ˆ

(1 )[(1 ) ] log

( (1 ) log( ))

(1 )

0 as .

(1 )

p u p d

n

u

p p p p

d

u

p p n

d

p p

n

np p

µ µ

σ

− + − −

− − −

·

−

− +

· → →∞

−

Hence the condition for the theorem to hold as stated in Equation (3.10) is satisfied.

References

Amram, M. and N. Kulatilaka, Real Options, Oxford University Press, USA, 2001.

Banz R. and M. Miller. “Prices for State Contingent Claims: Some Estimates and

Applications,” Journal of Business, Vol. 51 (1978, pp. 653-72).

Bhattachayra, M. “Empirical Properties of the Black-Scholes Formula under Ideal

Conditions,” Journal of Financial and Quantitative Analysis, 15 (December 1980,

pp. 1081-1105).

Bhattacharya, R. N. and R. R. Rao. Normal Approximations and Asymptotic

Expansions, New York: Wiley. 1976.

Black, F. “Capital Market Equilibrium with Restricted Borrowing,” Journal of

Business, 45 (July 1972, pp. 444-45)

Black, F. and M. Scholes. “The Pricing of Options and Corporate Liabilities,” Journal

of Political Economy, 31 (May-June 1973, pp. 637-59).

25

Bookstaber, R. M. Option Pricing and Strategies in Investing (Reading, MA: Addison-

Wesley, 1981).

Cox, J. c., and M. Rubinstein. Option Markets (Englewood Cliffs, NJ: Prentice-Hall,

1985).

Cox, J., S. A. Ross and M. Rubinstein. “Option Pricing: A Simplified Approach”.

Journal of Financial Economics, 7 (1979, pp. 229-263.)

Finnerty, J. “The Chicago Board Options Exchange and Market Efficiency,” Journal of

Financial and Quantitative Analysis, 13 (March 1978, pp. 29-38).

Galai, D. and R. W. Masulis. “The Option Pricing Model and the Risk Factor of Stock,”

Journal of Financial Economics, 3 (1976, pp. 53-81).

Hull, J., Options, Futures, and Other Derivatives (Sixth ed), Prentice Hall, 2005.

Jarrow R. and Turnbull S., Derivatives Securities (Second ed), South-Western College

Pub, 1999.

Liaw, K.T. and R. L. Moy, The Irwin Guide to Stocks, Bonds, Futures, and Options,

McGraw-Hill Companies, New York, 2000.

Lee, Cheng F., and Alice C. Lee, Encyclopedia of Finance, Springer, New York, New

York, 2006.

Lee, Cheng F., Handbook of Quantitative Finance, Springer, New York, New York, 2009.

Lee, Jack C., C. F. Lee, R. S. Wang and T. I. Lin. “On the Limit Properties of Binomial

and Multinomial Option Pricing Models: Review and Integration”. Advances in

Quantitative Analysis of Finance and Accounting New Series Volume 1. Singapore:

World Scientific 2004.

MacBeth, J. and L. Merville. “An Empirical Examination of the Black-Scholes Call

Option Pricing Model,” The Jollrnal of Finance, 34 (December 1979, pp. 1173-86).

26

McDonald, R.L., Derivatives Markets (Second ed.), Addison Wesley, Boston,

Massachusetts, 2005.

Rendleman, R. J., Jr., and B. J. Barter. “Two-State Option Pricing,” Journal of Finance,

24 (1979, pp.1093-1110).

Ritchken, P. Optiom: Theory, Strategy, and Applications (Glenview, IL: Scott,

Foresman 1987).

Summa, J.F. and J.W. Lubow, Options on Futures, John Wiley & Sons, New York,

2001.

Trennepohl, G. “A Comparison of Listed Option Premia and Black-Scholes Model

Prices: 1973-1979,” Journal of Financial Research, (Spring 1981, pp. 11-20)

Zhang, P.G., Exotic Options: A Guide to Second Generation Options (Second ed),

World Scientific Pub Co Inc, 1998.

27

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