Lecture 5: Binomial Trees

Based on Chapter 12 from

John C. Hull (2012). Options, Futures &
Other Derivatives, 8th ed., Prentice Hall.
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

now 3 months later

Financial Mathmatics 2
A Call Option
A 3-month European 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

now 3 months later

Financial Mathmatics 3
Setting up a Riskless Portfolio
Consider the portfolio: long D shares
short 1 call option
Portfolio values (3 months later) are:

22D 1

18D

Portfolio is riskless when 22D 1 = 18D, or D = 0.25.

Financial Mathmatics 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
220.25 1 = 4.50.
The value of the portfolio today is
4.5e0.120.25 = 4.3670.

Financial Mathmatics 5
Valuing the Option
The portfolio that is
long 0.25 shares
short 1 call option
is worth 4.367 today.
The value of the shares is
5.000 (= 0.25 20 )
The value of the option is therefore
0.633 ( 5.000 0.633 = 4.367 )
Financial Mathmatics 6
Generalization
A derivative lasts for time T and is dependent on
(the price of ) a stock, where u > 1 and d < 1:

S0 u stock price
u derivative price
S0

S0 d
d
now time T
Financial Mathmatics 7
Generalization (continued)
Value of a portfolio that is long D shares and short 1
derivative:
S0 u D u

S0 d D d
now time T
The portfolio is riskless when S0 u D u = S0 d D d ,
or
u f d
D
S 0u S 0 d
Financial Mathmatics 8
Generalization (continued)

Value of the portfolio at time T is S0 u D u

Value of the portfolio today is (S0 u D u)erT
Another expression for the portfolio value today
is S0 D f
Hence: S0 D = (S0 u D u)erT
= S0D (S0uD u)erT
Substituting for D we obtain: = [ pu + (1 p)d ]erT

e rT d
where p
ud
Financial Mathmatics 9
p as a Probability
It is natural to interpret p and 1-p as probabilities of up
and down movements (in a risk-neutral world).
The value of a derivative is then its expected payoff in
a risk-neutral world discounted at the risk-free rate
S0 u
u
S0

S0 d
d
now time T
Financial Mathmatics 10
Risk-Neutral Valuation
When the probabilities of 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.

Financial Mathmatics 11
Original Example Revisited
S0 u = 22
u = 1
S0 = 20

S0 d = 18
d = 0
now 3 months later
p is the probability that gives a return on the stock equal to the
risk-free rate:
20e 0.12 0.25 = 22p + 18(1 p) p = 0.6523
Alternatively: e rT d e 0.120.25 0.9
p 0.6523
ud 1.1 0.9
Financial Mathmatics 12
Valuing the Option Using Risk-Neutral Valuation
S0 u = 22
u = 1
S0 = 20

S0 d = 18
d = 0

now 3 months later

The value of the option is

e0.120.25 (0.65231 + 0.34770)
= 0.633

Financial Mathmatics 13
Irrelevance of Stocks Expected Return
When we are valuing an option in terms of the price of
the underlying asset, the probabilities of up and down
movements in the real world are irrelevant.
These real probabilities are already reflected in the assets
real prices.
This is an example of a more general result stating
that the expected return on the underlying asset in the
real world is irrelevant.
Higher risks should relate to higher expected returns, but we
dont know how high?
In a risk-neutral world, all assets have the same expected
return, which is the risk-free rate.

Financial Mathmatics 14
A Two-Step Example
(step-1 same as before)
24.2
22

20 19.8

18
16.2
now time T1 time T2
Strike price K = 21, risk-free rate r = 12%.
Each time step is 3 months.
Financial Mathmatics 15
Valuing a (6-month European) Call Option
24.2
3.2 (= 24.2 21)
22
B
20 2.0257 19.8
1.2823 A 0.0
18

0.0 16.2
0.0
Value at node B
= e0.120.25(0.65233.2 + 0.34770) = 2.0257.
Value at node A
= e0.120.25(0.65232.0257 + 0.34770) = 1.2823.
Financial Mathmatics 16
A (6-month European) Put Option Example
72
0
60
50 1.4147 48
4.1923 4
40
9.4636 32
20
now 1-year 2-year

Strike price K = 52, time step = 1 year.

r = 5%, u = 1.32, d = 0.8, p = 0.6282 = (erT d)/(u d)

Financial Mathmatics 17
What Happens If the Put Option is American
Option value at final nodes are
the same as for European options.
At earlier nodes, option value is
72
the greater of:
0
1. The value as given before
60
2. The payoff from early exercise.
50 1.4147 48
5.0894 4
40
The American feature C
increases the value at node C 12.0 32
from the previous 9.4636 to 12.0. = 52 40 20
This increases the value of
the option from 4.1923 to 5.0894.

Financial Mathmatics 18
Delta
Delta (D) is the ratio of the change in the price of a
stock option to the change in the price of the
underlying stock.
It is the number of units of the stock we should
hold for each option shorted in order to create a
riskless portfolio.
The construction of a riskless portfolio is
sometimes referred to as delta hedging.
The delta of a call option is positive, whereas the
delta of a put option is negative.
The value of D varies from node to node.
Financial Mathmatics 19
Choosing u and d
One way of matching the volatility is to set

u es Dt

d 1 u e s Dt

where s is the volatility and Dt is the length of the

time step: s Dt is the standard deviation of the
return on the stock price in a short period of time of
length Dt.
This is the approach used by Cox, Ross, and
Rubinstein (1979).

Financial Mathmatics 20
Girsanovs Theorem
Volatility is the same in the real world and the
risk-neutral world.
When we move from the real world to the risk-
neutral world the expected return on the stock
changes, but its volatility remains the same (at
least in the limit as Dt tends to zero).
We can therefore measure volatility in the
real world and use it to build a tree for the an
asset in the risk-neutral world.

Financial Mathmatics 21
Assets Other Than Non-Dividend Paying Stocks
For options on stock indices, currencies and futures, the basic
procedure for constructing the tree is the same except for the
calculation of p ---- the probability of an up move:
p = (a d) / (u d)
where
a = erDt for a non-dividend paying stock, or
a = e(r - q)Dt for a stock index where q is the dividend yield on the
index, or
a = e(r rf )Dt for a currency where rf is the foreign risk-free rate, or
a = 1 for a futures contract.

Financial Mathmatics 22
Proving the Black-Scholes-Merton (BSM) Theorem
from Binomial Trees
n
n!
ce rT
p j (1 p) n j max(S 0u j d n j K , 0)
j 0 ( n j )! j!
n ln( S 0 K )
Option is in the money when j > a where a
2 2s T n
so that
c e rT ( S 0U1 KU 2 )
where
n!
U1 p j (1 p ) n j u j d n j
j a ( n j )! j!

n!
U2 p j (1 p ) n j
j a ( n j )! j!

Financial Mathmatics 23
Proving the Black-Scholes-Merton (BSM) Theorem
from Binomial Trees (continued)
The expression for U1 can be written

U1 [ pu (1 p)d ]n
n!
j
p* 1 p*
n j
e rT
n!
j
p* 1 p*
n j

j a ( n j )! j! j a ( n j )! j!

where pu
p*
pu (1 p)d

Both U1 and U2 can now be evaluated in terms of the

cumulative binomial distribution.
We now let the number of time steps tend to infinity
and use the result that a binomial distribution tends to
a normal distribution.
Financial Mathmatics 24