Binomial Pricing Method

Introduction to Binomial
Trees
Chapter 12
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull 2013
A Simple Binomial Model

A
stock price is currently $20

In three months it will be either $22 or $18
Stock Price = $22
Stock price = $20
Stock Price = $18
Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull
2013
A Call Option (Figure 12.1, page 274)

A 3-month call option on the stock has a strike price of
21.
Up
Move
Stock price = $20

Option Price=?
Down
Move
Stock Price = $22

Option Price = $1
Stock Price = $18

Option Price = $0
2013
Setting Up a Riskless Portfolio
For a portfolio that is long shares and a short 1 call

option values are
Up
Move
is riskless when 22
2211 = 18
or = 0.25
Portfolio
Down
Move
18
2013
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
22 0.25 1 = 4.50
The value of the portfolio today is
4.5e 0.120.25 = 4.3670
2013
Valuing the Option

The
portfolio that is
long 0.25 shares
short 1 option
is worth 4.367
The value of the shares is
5.000 (= 0.25 20 )
The value of the option is therefore
0.633 (= 5.000 4.367 )
2013
Generalization (Figure 12.2, page 275)

A derivative lasts for time T and is
dependent on a stock
Up
Move
Su
u
Down
Move
Sd
d
2013
Generalization (continued)
Value of a portfolio that is long shares and short 1

derivative:
Up
Move
S0u u
Down
Move
S0d d
The portfolio is riskless when S0u u = S0d d or
u f d
S 0u S 0 d
2013
Generalization
(continued)
Value
of the portfolio at time T is

Su u
Value
of the portfolio today is

(Su u )erT
Another
expression for the

portfolio value today is S f
Hence = S (Su u )erT
2013
Generalization
(continued)
Substituting for we obtain

= [ pu + (1 p)d ]erT
where
e rT d
p
ud
2013
10
p as a Probability
It is natural to interpret p and 1p as the probabilities

of up and down movements
The value of a derivative is then its expected payoff in
discounted at the risk-free rate
S0
p
(1
p)
S0u
u
S0d
d
2013
11
Risk-Neutral Valuation
When the probability of an 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 riskfree 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
2013
12
Irrelevance of Stocks Expected

Return
When we are valuing an option in terms of
the underlying stock the expected return
on the stock is irrelevant
2013
13
Original Example Revisited

p
(1
p)
Su = 22
u = 1
Sd = 18
d = 0
e rT d e 0.120.25 0.9
p
0.6523
ud
1.1 0.9
Since p is a risk-neutral probability

20e0.12
0.25 = 22p + 18(1 p ); p = 0.6523
Alternatively, we can use the formula
2013
14
Valuing the Option Using RiskNeutral Valuation

S
3
2
5
6
0.
0.34
77
Su = 22
u = 1
Sd = 18
d = 0
The value of the option is

e0.120.25 [0.65231 + 0.34770]
= 0.633
2013
15
A Two-Step Example
Figure 12.3, page 280
24.2
22
19.8
20
18
16.2
Each
time step is 3 months

K=21, r =12%
2013
16
Valuing a Call Option

D
22
20
1.2823
2.0257
18
0.0
19.8
0.0
C
F
24.2
3.2
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
2013
17
A Put Option Example

50
4.1923
60
1.4147
40
9.4636
72
0
48
4
32
20
K = 52, time step =1yr

r = 5%, u =1.32, d = 0.8, p = 0.6282
2013
18
What Happens When the Put

Option is American (Figure 12.8, page 284)
72
0
60
50
5.0894
The American feature
increases the value at node
C from 9.4636 to 12.0000.
48
4
1.4147
40
12.0
C
32
20
This increases the value of

the option from 4.1923 to
5.0894.
2013
19
Delta
Delta
() is the ratio of the change

in the price of a stock option to the
change in the price of the
underlying stock
The value of varies from node to
node
2013
20
Choosing u and d
One way of matching the volatility is to set
u e
d 1 u e
where is the volatility andt is the length

of the time step. This is the approach used
by Cox, Ross, and Rubinstein (1979)
2013
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
2013
22
The Probability of an Up Move

p
ad
ud
a e rt for a nondividen d paying stock

a e ( r q ) t for a stock index where q is the dividend
yield on the index
( r r ) t
ae f
for a currency where r f is the foreign
risk - free rate
a 1 for a futures contract
2013
23
Increasing the Time Steps

In
practice at least 30 time steps are

necessary to give good option values
DerivaGem allows up to 500 time steps to
be used
2013
24
The Black-Scholes-Merton Model

The
BSM model can be derived by looking

at what happens to the price of a
European call option as the time step
tends to zero
See Appendix to Chapter 12
2013
25

Binomial Pricing Method

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Introduction to Binomial

A Simple Binomial Model

stock price is currently $20

A Call Option (Figure 12.1, page 274)

Stock price = $20

Stock Price = $22

Stock Price = $18

Setting Up a Riskless Portfolio

For a portfolio that is long shares and a short 1 call

Valuing the Portfolio

riskless portfolio is:

Valuing the Option

Generalization (Figure 12.2, page 275)

Value of a portfolio that is long shares and short 1

The portfolio is riskless when S0u u = S0d d or

of the portfolio at time T is

of the portfolio today is

expression for the

Substituting for we obtain

It is natural to interpret p and 1p as the probabilities

Irrelevance of Stocks Expected

Original Example Revisited

Since p is a risk-neutral probability

Valuing the Option Using RiskNeutral Valuation

The value of the option is

time step is 3 months

Valuing a Call Option

A Put Option Example

K = 52, time step =1yr

What Happens When the Put

This increases the value of

() is the ratio of the change

where is the volatility andt is the length

Assets Other than Non-Dividend

options on stock indices, currencies

The Probability of an Up Move

a e rt for a nondividen d paying stock

Increasing the Time Steps

practice at least 30 time steps are

The Black-Scholes-Merton Model

BSM model can be derived by looking

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