International Journal of IT, Engineering and Applied Sciences Research (IJIEASR) ISSN: 2319-4413

Volume 2, No. 2, February 2013

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On the Robustness of Binomial Model and Finite Difference
Method for Pricing European Options

Fadugba S. Emmanuel, Department of Mathematical Sciences, Ekiti State University, Ado Ekiti, Nigeria
Okunlola J. Temitayo, Department of Mathematical and Physical Sciences, Afe Babalola University, Ado
Ekiti, Nigeria
Adeyemo A. Oluwaseyi, Department of Mathematical and Physical Sciences, Afe Babalola University, Ado
Ekiti, Nigeria


ABSTRACT

This paper presents on the robustness of binomial model
and finite difference method for pricing European options.
Binomial model can be used to accurately price American
style options than the Black-Scholes model as it takes into
consideration the possibilities of early exercise and other
factors like dividends. Finite difference method is useful to
solve partial differential equations and provide a general
numerical solution to the valuation problems, as well as
an optimal early exercise strategy. The strengths and
weaknesses of the methods were considered. Finite
difference method is computationally efficient and more
accurate than binomial model for pricing European
options.

Keywords
American Option, Binomial Model, Black Scholes Model,
European Option, Finite Difference Method
.
1. INTRODUCTION

In the past two decades, options have been considered to
be the most dynamic segments of the security markets
since the inception of the Chicago Board Options
Exchange (CBOE) in April 1973, with more than one
million contracts per day, CBOE is the largest and
business option exchange in the world.

An option is a financial contract or a contingent claim that
gives the holder the right, but not the obligation to buy or
sell an underlying asset for a predetermined price called
the strike or exercise price during a certain period of time.
Options come in a variety of flavours. A vanilla option
offers the right to buy or sell an underlying security by a
certain date at a set strike price. In comparison to other
option structures, vanilla options are not fancy or
complicated. Such options may be well-known in the
markets and easy to trade. Increasingly, however,
the term vanilla option is a relative measure of complexity,
especially when investors are considering various options
and structures. Examples of vanilla options are an
American option which allows exercise at any point
during the life of the option and a European option that
allows exercise to occur only at expiration.

Black, Scholes and Merton approached the problem of
pricing an option in a physicist's way by assuming a
reasonable model for the price of a risky asset and since
then option valuation problem has gained a lot of
attention. In Black and Scholes (1973) [2] seminar paper
titled ``the pricing of options and corporate liabilities",
the assumption of log-normality was obtained and its
application for valuing various range of financial
instruments and derivatives is considered essential.

One of the major contributors to the world of finance was
Black and Scholes [2]. They ushered in the modern era of
derivative securities with a seminar paper titled ``Pricing
and Hedging of European call and put options". In this
paper, the famous Black-Scholes formula made its debut
and the Ito calculus was applied to finance. Later Merton
(1976) proposed a jump diffusion model. Boyle [3]
introduced a Monte Carlo approach for pricing options.
Twenty years later, Boyle, Brodie and Glasserman [4]
describe research advances that had improved efficiency
and broadened the types of problem where simulation can
be applied. Brennan and Schwarz [5] considered finite
difference methods for pricing American options for the
Black-Scholes leading to one dimensional parabolic
partial differential inequality. Cox, Ross and Rubenstein
[6] derived the tree methods of pricing options based on
risk-neutral valuation, the binomial option pricing
European option prices under various alternatives,
including the absolute diffusion, pre-jump and square
root constant elasticity of variance methods [5] just to
mention few. The complexity of option pricing formula
and the demand of speed in financial trading market
require fast ways to process these calculations; as a
result, the development of computational methods for
option pricing models can be the only solution.

In this paper, we shall consider the robustness of the
binomial model and finite difference method for pricing
European options.


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2. THE METHODS

This section presents two numerical methods for pricing
European options namely binomial model and finite
difference method.

2.1 BINOMIAL MODEL

This is defined as an iterative solution that models the
price evolution over the whole option validity period. For
some vanilla options such as American option, iterative
model is the only choice since there is no known closed
form solution that predicts its price over a period of time.
The Cox-Ross-Rubinstein Binomial model [6] contains
the Black-Scholes analytic formula as the limiting case as
the number of steps tends to infinity. Next we shall
present the derivation and the implementation of the
binomial model below.

2.1.1 THE COX-ROSS-RUBINSTEIN MODEL

We know that after a period of time, the stock price can
move up to Su with probability p or down to Sd with
probability ( p 1 ), where 1 > u and . 1 0 < < d
Therefore the corresponding value of the call option at
the first time movement t o is given by [6]

) 0 , max( K Su f
u
= (1)
) 0 , max( K S f
d d
= (2)
Where
u
f and
d
f are the values of the call option
after upward and downward movements
respectively.
We need to derive a formula to calculate the fair price of
vanilla options. The risk neutral call option price at the
present time is given by
] ) 1 ( [
d u
t r
f p pf e f + =
o
(3)

Where the risk neutral probability is given by
d u
d e
p
t r

=
o
(4)
Now, we extend the binomial model to two periods. Let
uu
f denote the call value at time t o 2 for two consecutive
upward stock movements,
ud
f for one downward and one
upward movement and
dd
f for two consecutive downward
movements of the stock price [9]. Then we have
) 0 , max( K Suu f
uu
= (5)

) 0 , max( K Sud f
ud
= (6)

) 0 , max( K Sdd f
dd
= (7)

The values of the call options at time t o are
] ) 1 ( [
ud uu
t r
u
f p pf e f + =
o
(8)

] ) 1 ( [
dd ud
t r
d
f p pf e f + =
o
(9)

Substituting (8) and (9) into (3), we have
[ (1 )
(1 ) ( (1 ) )]
r t r t
uu ud
r t
ud dd
f e pe f p f
p e pf p f
o o
o

= +
+ +

)] ) 1 ( ) 1 ( 2 [
2 2 2
dd ud uu
t r
f p f p p f p e f + + =
o
(10)
Equation (10) is called the current call value, where the
numbers
2
p , ) 1 ( 2 p p and
2
) 1 ( p are the risk
neutral probabilities for the underlying asset
prices Suu, Sud and Sdd respectively.
W generalize the result in (10) to value an option at
t N T o = as follows

=
N
j
d u
j N j
j
N t Nr
j N j
f p p C e f
0
) 1 (
o

=

=
N
j
j N j j N j
j
N t Nr
K d Su p p C e f
0
) 0 , max( ) 1 (
o
(11)
Where ) 0 , max( K d Su f
j N j
d u
j N j
=

and
! )! (
!
j j N
N
C
j
N

= is the binomial coefficient. We

assume that mis the smallest integer for which the
options intrinsic value in (11) is greater than zero. This
implies that K d Su
m N m
>

. Then (11) can be written as

=

=
N
j
j N j j N j
j
N t Nr
d u p p C Se f
0
) 1 (
o


0
(1 )
N
Nr t N j N j
j
j
Ke C p p
o
=

(12)
Equation (12) gives us the present value of the call option.
The term
t Nr
e
o
is the discounting factor that reduces f to
its present value. We can see from the first term of (12)
that -1is the binomial probability of j upward movements
to occur after the first N trading periods and
j N j
d Su

is
the corresponding value of the asset after j upward
movements of the stock price. The second term of (12) is
the present value of the options strike price.
Let
t r
e Q
o
= , we substitute Qin the first term of (12) to
yield
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=

=
N
j
j N j j N j
j
N N
d u p p C SQ f
0
) 1 (

0
(1 )
N
Nr t N j N j
j
j
Ke C p p
o
=

=

=
N
j
j N j
j
N
d p Q pu Q C S f
0
1 1
] ) 1 ( [ ] [

0
(1 )
N
Nr t N j N j
j
j
Ke C p p
o
=

(13)
Now, let ) , ; ( p N m u be the binomial distribution
function given by

= u
N
j
j N j
j
N
p p C p N m
0
) 1 ( ) , ; ( (14)
Equation (14) is the probability of at least m success in
N independent trials, each resulting in a success with
probability p and in a failure with probability ) 1 ( p .
Then let pu Q p
1
= ' and d p Q p ) 1 ( ) 1 (
1
= '

.
Consequently, it follows that
) , ; ( ) , ; ( p N m Ke p N m S f
rT
u ' u =

(15)
The model in (15) was developed by Cox-Ross
Rubinstein [6], where
N
T
t = o and we will refer to it as
CRR model. The corresponding put value of the
European options can be obtained using call put
relationship of the form S P Ke C
E
rt
E
+ = +

as
) , ; ( ) , ; ( p N m S p N m Ke f
rT
' u u =

(16)

Where the risk free interest rate is denoted by r ,
E
C is
the European call,
E
P is the European put and S is the
initial stock price. European option can only be exercised
at expiration, while for an American option, we check at
each node to see whether early exercise is advisable to
holding the option for a further time period t o . When
early exercise is taken into consideration, the fair price
must be compared with the options intrinsic value.

2.1.2 NUMERICAL IMPLEMENTATION [8]

Now, we present the implementation of binomial model
for pricing vanilla options as follows.

When stock price movements are governed by a multi-step
binomial tree, we can treat each binomial step separately.
The multi-step binomial tree can be used for the American
and European style options.

Like the Black-Scholes, the CRR formula in (15) can only
be used in the pricing of European options and easily be
implemented in Matlab. To overcome this problem, we
use a different multi-period binomial model for the
American style options on both the dividend and non-
dividend paying stocks. Now we present the Matlab
implementation.

The stock price of the underlying asset for non-dividend
and dividend paying stocks are given respectively by
1 ,... 1 , 0 , ,..., 1 , 0 , = =

i N N j d Su
j N j
(17)

,... 1 , , ,..., 1 , 0 , ) 1 ( + = =

i i N N j d u S
j N j
(18)

Where the dividend is denoted by that reduces
underlying price of the asset. For the European call and
put options, the Matlab code takes into consideration on
the prices at the maturity date T and the stock prices for
non-dividend paying stocks in (17). The call and put prices
of European option are given by (15) and (16)
respectively.

For the American call and put options, the Matlab code
will incorporate the early exercise privilege and the
dateT , when the dividend will be paid. Then, it implies
that the stock prices will exhibit (17) and (18). The call
and put prices of American option for non-dividend
paying stock are given by

))] , ; ( ) , ; ( ( , max[ p N m Ke p N m S K S f
rT
T
u ' u =

and
))] , ; ( ) , ; ( ( , max[ p N m S p N m Ke S K f
rT
T
' u u =


respectively. For dividend paying stock, we replace (17)
with (18) in (12) and substitute in the last two equations to
get respectively the call and put prices of American
option.

2.2 FINITE DIFFERENCE METHOD

Many option contract values can be obtained by solving
partial differential equations with certain initial and
boundary conditions. The finite difference approach is one
of the premier mathematical tools employed to solve
partial differential equations. These methods were
pioneered for valuing derivative securities by Brennan and
Schwarz [5]. The most common finite difference methods
for solving the Black-Scholes partial differential equations
are the
- Explicit Method.
- Implicit Method.
- Crank Nicolson method.
These schemes are closely related but differ in stability,
accuracy and execution speed, but we shall only consider
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implicit and Crank Nicolson schemes. In the formulation
of a partial differential equation problem, there are three
components to be considered.
- The partial differential equation.
- The region of space time on which the partial
differential is required to be satisfied.
- The ancillary boundary and initial conditions to
be met.

2.2.1 DISCRETIZATION OF THE
EQUATION

The finite difference method consists of discretizing the
partial differential equation and the boundary conditions
using a forward or a backward difference approximation.
The Black-Scholes partial differential equation is given by
) , (
2
) , (
2 2
t S S
t
S t t t
S t rf f
S
f rS S t f
t t t
= + +
o

(19)

We discretize (1) with respect to time and to the
underlying price of the asset. Divide the ) , (
t
S t plane
into a sufficiently dense grid or mesh and approximate
the infinitesimal steps
t
A and
t
S
A by some small fixed
finite steps. Further, define an array of 1 + N equally
spaced grid points
N
t t ,...,
0
to discretize the time
derivative with
t n n
N
T
t t A = =
+1
. Using the same
procedures, we obtain for the underlying price of the
asset as follows:
t
S M M
M
S
S S A = =
+
max
1
.

This gives us a rectangular region on the ) , (
t
S t plane
with sides ) , 0 (
max
S and ) , 0 ( T . The grid coordinates
) , ( m n enables us to compute the solution at discrete
points. We will denote the value of the derivative at time
step
n
t when the underlying asset has value
m
S as

) , ( ) , ( ) , (
, t m n n m
S t f S t f S m t n f f = = A A =

(20)
where n and m are the numbers of discrete increments
in the time to maturity and stock price respectively.

2.2.2 FINITE DIFFERENCE
APPROXIMATIONS

In finite difference method, we replace the partial
derivative occurring in the partial differential equation by
approximations based on Taylor series expansions of
function near the points of interest [9]. Expanding
) , ( S S t f + A and ) , ( S S t f A in Taylor series we
have the forward and backward difference respectively
with ) , ( S t f represented in the grid by
m n
f
,
[1]:

t
m n m n
S
S
f f
f
t
A

~
+ , 1 ,
(21)


t
m n m n
S
S
f f
f
t
A

~
1 , ,
(22)

Also the first order partial derivative results in the
central difference given by
t
m n m n
S
S
f f
f
t
A

~
+
2
1 , 1 ,
(23)

And the second order partial derivative gives symmetric
central difference approximation of the form
2
1 , , 1 ,
2
t
m n m n m n
S S
S
f f f
f
t t
A

~
+
(24)

Similarly, we obtained forward difference approximation
for the maturity time given by
t
m n m n
t
S
f f
f
A

~
+ , , 1
(25)

Substituting equations (23), (24) and (25) into (19), we
have
m n m n m m n m m n m
f f f f
, 1 1 , 3 , 2 1 , 1 + +
= + + (26)
Where
t m t rm
m
A A =
2 2
1
2
1
2
1
o
t m t r
m
A + A + =
2 2
2
1 o ,
t m t rm
m
A A =
2 2
3
2
1
2
1
o ,
(26) is called a finite difference equation which gives
equation that we use to approximate the solution
of ) , ( S t f [4].
Similarly, we obtained for the explicit, implicit and Crank
Nicolson finite difference method as follows [7]:
Explicit case:
m n m n m m n m m n m
t
f f f f
r
, 1 , 1 3 , 1 2 1 , 1 1
) (
1
1
= + +
+
+ + + +
o o o
o

(27)
Where
t m
t t
m
m
rm m
o o o
o o o
o
2 2
2
2 2
1
1 ,
2 2
= =
and
2 2
2 2
3
t t
m
rm m o o o
o + = .
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This method is accurate to ) (
2
,
S
t
O o o .
For implicit case we have,
m n m n m m n m m n m
t
f f f f
r
, 1 1 , 3 , 2 1 , 1
) (
1
1
+ +
= + +

| | |
o
(28)
Where the parameters in (28) are given
by
t m
t t
m
m
rm m
o o |
o o o
|
2 2
2
2 2
1
1 ,
2 2
+ = + =
and
2 2
2 2
3
t t
m
rm m o o o
| = .
Similar to the explicit method, implicit method is accurate
to ) (
2
,
S
t
O o o .
Crank Nicolson method is obtained by taking the average
of the explicit and implicit methods in (27) and (28)
respectively. Then we have
1 , 1 2 , 3 , 1
1 1, 1 2 1, 3 1, 1
m n m m n m m n m
m n m m n m m n m
f f f
f f f
v v v
| | |
+
+ + + + +
+ +
= + +
(29)
Then the parameters are given by
4 4
2 2
1
t m t rm
m
A

A
=
o
v ,
2 2
1
2 2
2
t m t r
m
A
+
A
+ =
o
v ,
4 4
2 2
3
t m t rm
m
A

A
=
o
v
4 4
2 2
1
t m t rm
m
A
+
A
=
o
,
2 2
1
2 2
21
t m t r
m
A

A
=
o
,
.
4 4
2 2
3
t m t rm
m
A
+
A
=
o

1 ,..., 2 , 1 , 0 = N n and 1 ,..., 2 , 1 = M m [8].

2.2.3 STABILITY ANALYSIS

The two fundamental sources of error are the truncation
error in the stock price discretization and in the time
discretization. The importance of truncation error is that
the numerical scheme solves a problem that is not exactly
the same as the problem we are trying to solve.

The three fundamental factors that characterize a
numerical scheme are consistency, stability and
convergence [9, 10].
- Consistency: A finite difference of a partial
differential equation is consistent, if the
difference between partial differential equation
and finite differential equation vanishes as the
interval and time step size approach zero.
Consistency deals with how well the finite
difference equation approximates the partial
differential equation and it is the necessary
condition for convergence.
- Stability: For a stable numerical scheme, the
errors from any source will not grow
unboundedly with time.
- Convergence: It means that the solution to a finite
difference equation approaches the true solution
to the partial differential equation as both grid
interval and time step sizes are reduced. The
necessary and sufficient conditions for
convergent are consistency and stability.

These three factors that characterize a numerical
scheme are linked together by Lax equivalence
theorem [9] which states that given a well posed
linear initial value problem and a consistent finite
difference scheme, stability is the necessary and
sufficient condition for convergence.

In general, a problem is said to be well posed if:
- A solution to the problem exists.
- The solution is unique when it exists.
- The solution depends continuously on the
problem data.

2.2.3.1 A NECESSARY AND
SUFFICIENT CONDITION FOR
STABILITY
Let
n n
Af f =
+1
be a system of equations, where
Aand
1 + n
f are matrix and column vectors
respectively. Then

1
=
n n
Af f

2
2

=
n
f A


0
f A
n
= (30)
For N n ,..., 2 , 1 = and
0
f is the vector of initial
value. We are concerned with stability and we also
perturbed the vector of the initial value
0
f to
0
t . The
exact solution at the
th
n row will then be

0
t A t
n
n
= (31)
Let the perturbation or error vector e be denoted by
f t e =
and using the perturbation vectors (30) and (31), we
have

n n n
f t e =

0
f A
n
=
0
t A
n

= ) (
0 0
f t A
n

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Therefore,

0
e A e
n
n
= (32)
Hence for compatible matrix and vector norms [11]

n
n
A e s
0
e
Lax and Richmyer defined the difference scheme to be
stable when there exists a positive number L which is
independent of n ,
t
o and
s
o , then L A s . This limits
the amplification of any initial perturbation and therefore
of any arbitrary initial rounding errors, since
L e
n
s
0
e and
n
n
A A s , then the Lax-
Richmyer definition of stability is satisfied when
1 s A (33)
Hence (33) is the necessary and sufficient condition for
the finite difference equations to be stable [11]. Since
the spectral radius ( ) A satisfies A A s ) ( , it
follows from (33) that 1 ) ( s A .

By Lax equivalence theorem, the three finite difference
methods are consistent and convergent but in the analysis
of their stability, explicit method is quite stable, while the
implicit and Crank Nicolson methods are conditionally
and unconditionally stable finite difference methods
respectively because they calculate small change in the
option value for a small change of the initial conditions,
converge to the solution of the partial differential
equation and calculation error decreases when number of
time and price partitions increase.

3. NUMERICAL EXAMPLES

This section presents some numerical examples as
follows:

Example 1

We consider the convergence of the binomial model and
the Crank Nicolson finite difference method with relation
to the Black-Scholes value of the option.
We price the European call option on a non-dividend
paying stock with the following parameters:
1 , 2 . 0 , 05 . 0 , 60 , 50 = = = = = T r K S o
The Black-Scholes price for the call option is 1.6237.
Table 1and 2 below shows the illustrative result for the
performance of the two methods under consideration
when the value of M and N are the same and different
respectively.




Example 2

We shall consider the robustness of the two methods
against the true Black-Scholes price for a European put
with the parameters
50, 0.05, 0.25, 3 K r T o = = = =
The result obtained is shown in Table 3 below.

3.1 TABLE OF RESULTS

Table 1: The comparison of the convergence of the
Implicit method and the Crank Nicolson method as we
increase M and N
M N =
Binomial
Model
Crank Nicolson
Finite Difference
Method
10 1.6804 1.3113
20 1.5900 1.4957
30 1.6373 1.5423
40 1.6442 1.5603
50 1.6386 1.5692
60 1.6289 1.5743
70 1.6179 1.5776
80 1.6178 1.5798
90 1.6254 1.5814
100 1.6293 1.5826

Table 2: The Illustrative Result for the Performance of
Binomial method and the Crank Nicolson Finite
Difference Method for different values of M and N
M N
Binomial
Model
Crank Nicolson
Finite Difference
Method
10 20 1.6804 1.5731
20 40 1.5900 1.6108
30 60 1.6373 1.6180
40 80 1.6442 1.6205
50 100 1.6386 1.6216
60 120 1.6289 1.6222
70 140 1.6179 1.6225
80 160 1.6178 1.6227
90 180 1.6254 1.6229
100 200 1.6293 1.6230

Table 3: A Comparison with the Black-Scholes Price for
a European Put Option


S
Black-
Scholes
Binomial
Model
Finite Difference
Method
50 4.9564 4.9556 4.9563
60 2.7621 2.7640 2.7612
70 1.5328 1.5346 1.5325
80 0.8538 0.8549 0.8537
90 0.4797 0.4803 0.4794

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3.2 DISCUSSION OF RESULTS

Table 1 shows that the binomial model is closer to the
Black-Scholes values for small values of N than the
Crank Nicolson finite difference method as N ,
0
t
o and M , 0
s
o .

Table 2 shows that when N and M are of different
values, the finite difference method converges faster than
its counterpart binomial model when N is equal to M .
For Crank Nicolson scheme, the number of time steps
N initially set at 10and doubled with each grid
M refinement. We conclude that the Crank Nicolson
finite difference method has a higher accuracy than the
implicit method and therefore it converges faster. The
above results highlight that the two methods are stable.

Table 3shows the variation of the option price with the
underlying price S . The results demonstrate that the two
methods perform well, are mutually consistent and agree
with the Black-Scholes value. However, in general finite
difference method is far better suited for the pricing of this
contract.

4. CONCLUSION

Options can be classified into two flavours namely vanilla
and exotic. Binomial model and finite difference method
are suited to dealing with some of these option flavours.

In general, each numerical method has its strengths and
weaknesses of use. Binomial model is good for pricing
options with early exercise opportunities, accurate,
converges faster as we can see in Table 1 and it is
relatively easy to implement but can be quite hard to adapt
to more complex situations.

Finite difference methods require sophisticated algorithms
for solving large sparse linear systems of equations but
cannot be used in high dimensions. They are flexible in
handling different processes for the underlying state
variables and relatively difficult to code but these methods
are somewhat problematic for path dependent options.
From Tables 2 and 3, we conclude that finite difference
method is more stable, accurate, converges faster and it is
more robust than its counterpart binomial model when
pricing European options.

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