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The Binomial Model Introduction Pricing an Option in the Binomial Model Example Constructing a risk-free portfolio Valuing the option The Binomial Tree Distribution Valuing using backward induction Continuous-time limit Summary
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Overview
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The Binomial Model Introduction Pricing an Option in the Binomial Model Example Constructing a risk-free portfolio Valuing the option The Binomial Tree Distribution Valuing using backward induction Continuous-time limit Summary
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This lecture. . .
This lecture consists of A simple model for an asset price random walk, delta hedging, no arbitrage, the basics of the binomial method for valuing options, risk neutrality.
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Introduction
The most accessible approach to option pricing is the binomial model. This model has the following features: basic arithmetic and no complicated stochastic calculus, ideas of hedging and no arbitrage are present, a simple algorithm for determining the correct value for an option.
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Up or Down Movements
In the binomial model we assume that the asset, which initially has the value S, can, during a timestep t, either move up or down,
1 2 3
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Price movements
The three constants u, v and p are chosen to give the binomial walk the same drift and standard deviation as the asset we are trying to model.
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Overview
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The Binomial Model Introduction Pricing an Option in the Binomial Model Example Constructing a risk-free portfolio Valuing the option The Binomial Tree Distribution Valuing using backward induction Continuous-time limit Summary
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Example
Example Let u = 1.01, v = 0.99, p = 0.55. The current asset price S is 100 so there is a 55% chance that the stock price will next be 101 and a 45% chance it will be 99. What does next mean and how were these numbers chosen? Next means after a small timestep, say one day. So we will be looking at what happens from one day to the next. How we chose u, v and p is something we will come back to shortly.
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Portfolio
Now let us assume that we hold a call option on this asset that is going to expire tomorrow (t = 1 day). This option has a strike of 100. Holding just the stock or the option is risky: Stock If the asset rises we have 101, a prot of 1, whereas if it falls we have 99, a loss of 1. Option If the asset rises to 101 we get a payoff of 1. If it falls to 99 we get no payoff, the asset expires out of the money.
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A portfolio
Let us sell short a quantity, , of the underlying asset so that now we have a portfolio consisting of a long option position and short stock position. Up If the asset rises to 101 we have a portfolio worth max(101 100, 0) ( 101) = 1 101 Down If the asset falls we have max(99 100, 0) ( 99) = 99 This portfolio is risky in the sense that there are two values that it can take, we dont know what the portfolio will be worth. Or is it in fact risky?
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Suppose we choose such that 1 101 = 99, i.e. = 1 , 2 then whether the asset rises or falls our portfolio has a value of: 1 101 = 99 = 99 . 2
There is no risk, we are guaranteed this amount of money irrespective of the behaviour of the underlying. This is hedging.
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Step 2 contd.
This must be the same as the portfolio value today so 1 1 99 V (100) = V 100 = V 50 = r 2 1 + 252 2 . Put in the relevant r and calculate V from this, V = 50 1 99 r 1 + 252 2
. Simple. Note that Ive assumed 252 business days in one 1 year so that t = 252 . If r = 10% then V = 0.5196.
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The conclusion is that the option value depends on the interest rate, the payoff, the size of the up move, the size of the down move and the timestep. Probabilities are irrelevant! But it does not depend on the probability of the up move. p never came into the calculation. This is very counter-intuitive. Surely the value of an option depends on whether the asset is likely to go up or down. It turns out that this is not the case. We will expand on this idea further shortly, but rst lets do the same calculation in general.
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The expected asset price after one timestep t is puS + (1 p)vS = (1 + t)S. So the expected change in the asset is St. The expected return is t. This is something that is measurable given statistical information on the asset data.
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The variance in change in asset price is S 2 2 t, so the standard deviation of asset changes is S t The standard deviation of returns is t We can measure and statistically.
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to get:
r t 2 .
where p =
1 2
Note that p is not the probability p of a rise in value, which was p = 1 + 2t . We call p the risk-neutral probability. 2 Observe that the risk-free interest plays two roles in option valuation. It is used once for discounting to give present value, and also as the drift rate in the asset price random walk.
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What happened to the probability p and the drift rate ? Interpreting p (from the previous slide) as a probability, is the statement that the option value at any time is the present value of the expected value at any later time. That is because the up move value V + is multiplied by a probability and the down move value V is multiplied by one minus that probability.
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Overview
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The Binomial Model Introduction Pricing an Option in the Binomial Model Example Constructing a risk-free portfolio Valuing the option The Binomial Tree Distribution Valuing using backward induction Continuous-time limit Summary
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Binomial Tree
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Binomial Tree
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The top and bottom branches of the tree at expiry can only be reached by one path each, either all up or all down moves. There will be several paths possible for each of the intermediate values at expiry. Therefore the intermediate values are more likely to be reached than the end values if one were doing a simulation. The binomial tree contains within it an approximation to the probability density function for the lognormal random walk.
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The probability of reaching a particular node in the binomial tree depends on the number of distinct paths to that node and the probabilities of the up and down moves. Since up and down moves are approximately equally likely and since there are more paths to the interior prices than to the two extremes we will nd that the probability distribution of future prices is roughly bell shaped.
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Knowing these values means that we can nd the option values one step further back in time. Thus we work our way back down the tree until we get to the root. This root is the current time and asset value, and thus we nd the option value today.
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The possible nal stock prices are: $72, $48, and $32.
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f = e20.051 (0.62822 0+20.6282.37184+0.37182 20) = 4.1 The value of the put is $4.1923, we could get this gure from working back through the tree also.
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American Options
Work back through the tree from the end to the beginning, testing at each node to see if early exercise is optimal. The value of the option at the nal nodes is the same as that of the European option. At earlier nodes the value of the option is the greater of: 1 V = ert (p V + + (1 p )V ), 2 The payoff from early exercise.
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American option valuation At the initial node A, the value of the option is e0.051 (0.6282 1.4147 + 0.3718 12.0) = 5.0894, and the payoff from early exercise is 2. In this case early exercise is not optimal
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Delta ()
Delta () is the ratio of the change in the price of the stock option to the change in the price of the underlying ( V ). S The value of varies from node to node. This is one of the Greeks that we will come back to in later lectures.
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1 (p V + + (1 p )V ), r t
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Towards Black-Scholes...
If we also let V = V (S, t), V + = V (uS, t + t) and V = V (vS, t + t), we can expand these expressions in Taylor series for small t and substitute for V , V + and V to get: V 1 2V V + 2S2 2 + r rV = 0 t 2 S S (1)
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Summary A simple model for an asset price random walk, delta hedging, no arbitrage, the basics of the binomial model for valuing options, risk neutrality.