3/05/2018 3:06 AM

TO: Rowena Chan Grant, Founder at Elmtree Migration Lawyers

SUBJECT: Memorandum on the No-arbitrage and Binomial options pricing methods

From: Tony He, Legal Assistant

NO-ARBITRAGE MOGEL:

 The No-Arbitrage Model attempts to find out how many shares per option one needs to take
out.
 Afterwards, by taking out that amount of shares, one is able to make their portfolio risk-free.
 The buy-product of this is that one is able to value the option used to create such a portfolio.
 Observe: ASSUME RISK-FREE rate = 10%, and the change in price occurs in 6 months’ time

 SO: To establish the riskless portfolio with these facts, we:

 Let 40Δ – 2 = 32Δ
 Therefore, 8Δ = 2, Δ = 0.25
 Therefore, we need to long 0.25 of a share per option we take out.

 IF we do indeed long 0.25 of a share, then

 If the price moves to $40, the value of the portfolio = 40 x 0.25 – 2 = $8
 And if the price moves to $32, the value of the portfolio = 40 x 0.25 = $8

 To then actually PRICE the option for TODAY:

 Calculate: 35 x Δ - price of option today
 Discount the value of the portfolio to now:
 8 x e-0.1 x 6/12 = $7.61
 Therefore: 35 x 0.25 – price today = 7.61
 Therefore: 8.75 – price today = 7.61
 Therefore: price today = $1.14

THIS MEANS THAT:

If there are no arbitrage opportunities, then the value of the option must be $1.14.
If the value of the option was more than $1.14, the portfolio would earn more than the risk-free rate
but be cheaper than $7.61 to set up.
If the value of the option was less than $1.14, then shorting the portfolio of its stocks would be a
way of borrowing money at less than the risk-free rate.
3/05/2018 3:06 AM

THE Binomial Model:

 This model relies on us firstly finding out the probability of an upstate and a downstate, and
then using that probability in an expected value function to determine the price of the option.

This method involves:

 Calculating Delta (if required):

 Calculating u:
 Can either: do Su/S0, OR:
 If they only give volatility, Use the formula:

 Calculating d:
 Can either: do Sd /S0, OR:
 If they only give volatility, use the formula:

 Finding the value of p, which is the probability of the upstate,

 Use the formula:

 Noting especially that T must be divided by n, where n is the number of timesteps we have
in total.

 You can then of course find the probability of the downstate by doing 1 – p

 Finding the value of the option:

 Use the formula: f = [p fu + (1-p) fd ] x e-rT

 What you do is you always work backwards one step at a time.

3/05/2018 3:06 AM

APPLICATION TO THE SCENARIO:

U = 40/35 = 1.14286
D = 32/35 = 0.91429

Therefore, p = 0.59930, and 1 – p = 0.4007

Therefore, the value of the option is:

(0.59930x 2 + 0.4007x 0) x e – 0.1*6/12 = x 0.95123 = 1.14 just like with the no arbitrage model!!!

RE: AMERICAN OPTIONS:

 The thing with American options is that they can be exercised early
 When determining whether to exercise early, the function is:
 Max(IV, [p fu + (1-p) fd ] x e-rT) where IV is the intrinsic value that one receives from an option
at a particular point in time.
 This means that you are comparing the value of the option at a particular point in time, with
the payoff from that option at that point in time if you were to exercise early.