Derivative Securities

Forwards and Options

381 Computational Finance

Imperial College
London

Computational Finance 1/47

 Topics Covered

 Derivatives:

Forward Contracts, Options

Valuation techniques
Option Pricing Models

Binomial Option Pricing

Computational Finance 2/47

 Introduction to Derivatives
 security
whose payoff is explicitly tied to value or price of other financial security
that determines value of derivative is called underlying security
derivatives

arise when individuals or companies wish to buy asset or commodity in

advance to insure against adverse market movements;
effective tools for hedging risks – designed to enable market participants to
eliminate risk.
business dealing with a good faces risk associated with price fluctuations.
control that risk through use of derivative securities.
Example:
 farmer can fix price for crop even before planting, eliminating price risk
an exporter can fix a foreign exchange rate even before beginning to
manufacture product, eliminating foreign exchange risk.

Computational Finance 3/47

 Example 1: Derivatives
 A forward contract to purchase 2000 pounds of sugar at 12 cents
per pound in 6 weeks.
 The contract is a derivative security because its value is derived from
the price of sugar.
 No reference to payoff - contract only guarantees purchase of sugar.
 The payoff is implied and determined by the price of sugar in 6 weeks.
 If price of sugar was 13 cents per pound, then contract would have a
value of 1 cent per pound,
Strategy: the owner of contract could
 buy sugar at 12 cents according to the contract
 then sell that sugar in the sugar market at 13 cents.

Computational Finance 4/47

 Example 2: Derivatives

Assume that a contract gives one the right, but not the obligation to
purchase 100 shares of GM stock for $60 per share in exactly 3 months.
 This is an option to buy GM.
 Payoff of option will be determined in 3 months by the price of GM
stock at that time.
 If GM is selling then for $70, the option will be worth $1000
The owner of option could at that time
purchase 100 shares of GM for $60 per share according to
option contract,
 immediately sell those shares for $70 each

Computational Finance 5/47

 Forward Contracts
Forward contract is specified by a legal document, the terms of which bind
two parties involved to a specific transaction in the future.
on a priced asset is a financial instrument, since it has an intrinsic value
determined by the market for underlying asset
on a commodity is a contract to purchase or sell a specific amount of
commodity at specific time in future at a specific price agreed upon
today
Contract is between two parties, buyer and seller.
buyer (long ): obligated to take delivery of asset & pay agreed-upon
price at maturity
seller (short): obligated to deliver asset & accept agreed-upon price at
maturity
Claims are settled at defined future date; both parties must carry out their
side of agreement at that time.
Forward price applies at delivery, negotiated so that initial payment is zero.
Computational Finance 6/47
 Replicating Portfolio
– used to find the value of derivatives
– derivatives can be replicated using other securities
– portfolio that replicates a forward contract is obtained
– price of the portfolio is the forward contract's price
Notation:

S 0 : current stock price

ST : stock price at maturity of the contract
r : interest rate for period between now (t  0) and (t  T )
F : price of forward contract
DT : cumulative value of all dividends paid from now to maturity
d : dividend yield of the stock (annual percentage rate)

Computational Finance 7/47

 Standard Formulation: Discrete Compounding
Assumptions:
 buy one unit commodity at price S0 with no dividend payment
 enter a forward contract to deliver at T one unit at price F
 store until T with no cost, deliver to meet our obligation & obtain F
 Cash flow sequence in two market operations is ( - S0 , F ) fully
determined at t = 0 consistent with interest rate between t = 0 and T
 For asset with zero storage cost, current spot price S0 , forward price F
is calculated as
S0  d (0, T )  F where d (0, T ) is discount factor

 Buying the commodity at price S0 = lending amount S0 of cash for

which we will receive an amount F at time T since storage costless.

Computational Finance 8/47

 Arbitrage Portfolio

S0
Assume that F
d (0, T )
 borrow S0 cash and buy one unit of the underlying asset
 take one-unit short position (sell) in forward market
 at T, deliver asset receiving cash amount F & repay our loan in amount
S
 obtain positive profit of F  0
d (0, T ) for zero net investment
S0
F
Assume that d (0, T )
 shorting one unit of underlying asset: borrow asset from s.o who plans to store
it during this period, then sell borrowed asset and replace borrowed asset at T
 take one-unit long position (buy) in forward market
S0
 at T, receive d (0, T ) from loan and pay F one-unit of asset and return
this to lender who made the short possible
S0
profit is F
d (0, T )
Computational Finance 9/47
 Dividend Payment with Discrete Compounding

 stock pays dividend with total cumulative value for T=1 year DT  (1  r ) D0
 two strategies for constructing portfolios A and B
◊ buy a share for S0 and sell share forward in T for forward price F
◊ invest S0 at risk free interest rate of r
Strategy Payoff now Payoff at maturity
Buy stock -S0 ST +DT
Sell stock forward 0 F-ST
Invest at risk-free rate -S0 (1+r)S0
Portfolio A -S0 F +DT
Portfolio B -S0 (1+r)S0

Both portfolios have the same payoff values, the forward price is
F  S 0 (1  r )  DT or F  ( S 0  D0 )(1  r )
If stock pays no dividend, F  S0( 1  r)
Computational Finance 10/47
 Example
Consider a stock is trading at £145 today and pays no dividend during the next 3 months.
Annual interest rate is 8%. What is forward price under monthly compounding?

Portfolio A: buy a share for £145 and sell share forward in 3 months for forward
price F
Portfolio B: invest £145 in a bank account at risk free interest rate of 8%

Strategy Today (t=0) 3 months from now

Buy stock -145 ST
Sell stock forward 0 F-ST
Portfolio A -145 F
Portfolio B -145 147.9193
Payoff of portfolio A is certain & equal to F although we do not know price of
stock after 3 months.
3
 0.08 
We invest £145 today in a risk-less bank account and receive 145  1    147.9193
 12 
Considering no arbitrage rule: two portfolios must have the same payoff F = 147.9193

Computational Finance 11/47

 Example Continued: Forward Arbitrage
No-arbitrage: prices must adjust so that no market participant can make a riskless profit
Case 1: Forward contract is overpriced as F= 149

Strategy Today (t=0) 3 months from now

Borrow £145 +145 -147.9193
Buy stock -145 +ST
Sell forward 0 149-ST
Total 0 1.08
Case 2: Forward contract is under priced as F= 143

Strategy Today (t=0) 3 months from now

Borrow and sell stock +145 - ST
Buy stock forward 0 ST-143
Invest £145 at risk free rate -145 +147.9193
Total 0 4.9193

RESULT: Only price in the arbitrage free market F = 147.9193

Computational Finance 12/47
 Dividend Payment-Continuous Compounding
 If stock pays dividends we need to buy e  dT units of stock –smaller than 1 unit
 obtain dividends while holding the stock, reinvesting the dividends enables us to
purchase another 1  e  dT units of the stock

At maturity we own exactly 1 unit of the stock

Strategy Payoff now Payoff at maturity

Buy e-dT units stock- -S0 e-dT ST
reinvest dividends
Sell 1 unit of stock 0 F-ST
forward
Borrow S0 e-dT S0 e-dT [-S0 e-dT] erT
Total 0 F - S0 e(r-d)T
Arbitrage free markets require that total payoff of the portfolio is zero at maturity

 S0e rT if the stock pays no dividends

F   ( r  d )T
S0e if the stock pays dividends
Computational Finance 13/47
 Example
Consider a six-month forward contract on a stock that is currently trading at £95 and has
a dividend yield of 2%. The risk free rate is 7%. Show that the 6-month forward should be
priced at £97.40.
If you buy e  dT  e0.02( 0.5)  0.99 units of stock, you invest 0.99x95 = 94.05
You also reinvest all dividends, so in 6 months you own 1 unit of stock
sell this unit forward so return on your portfolio is riskless
invest your £94.05 at the risk free rate, and obtain a payoff

94.05e 0.50.07  97.40

F  S 0 e ( r  d )T
 95e( 0.07  0.02) 0.5  97.40
An arbitrage profit can be obtained
selling stock and buying it back forward, investing proceeds in bonds if F < 97.40
buying stock and selling it forward, where we would borrow the money
to purchasing the stock, if F > 97.40

Computational Finance 14/47

 Commodity Forwards

 owner of commodities has to maintain their value,

 requires storage (wheat, gold), feeding (live hogs), or
security (gold)
 cost is called cost of carry
 expressed as an annual percentage rate q
 It is treated as a negative dividend.
 the valuation formula for commodity forwards is
obtained as
F  S 0 e ( r  q )T

Computational Finance 15/47

 Options
Holder of forward contract is obliged to trade at maturity of contract
Unless the position is closed before maturity, the holder must take possession of
the commodity, currency or whatever is the subject of the contract, regardless of
whether the price of the underlying asset has risen or fallen.

An option gives holder a right to trade in the future at a previously agreed price
but takes away the obligations. If stock falls, we do not have to buy it after all.

An option is a privilege sold by one party to another that offers the buyer the right
to buy or sell a security at an agreed-upon price during a certain period of time or
on a specific date.
Option holder has the right to chose to purchase a stock at a set-price within a certain period
Option writer has the obligation to fulfil the choice of the holder:
 deliver the asset (for call option ) OR buy the asset (for put option )
 receives the premium

Computational Finance 16/47

 Example: Real life

You have seen a sale on a TV for £120 in a newspaper. You go to shop to purchase it at the
advertised price. Unfortunately at that time the TV is already out-of stock. But the manager gives
you a rain-check entitling you to buy the same TV for the advertised price of £120 anytime within the
next 2 months.
You have just received a call option:
– gives you the right, but not the obligation, to buy the TV in the future
– at the guaranteed strike price of £120
– until the expiration date of 2 months

Scenario 1: A few weeks later you go to exercise your rain check -

– TV is now in stock and priced at £150. Since you have a rain check the store manager
agrees to issue the rain check and
sells you TV at £120. SAVED £30
–TV is now in stock but on sale for £100. Your rain check is worthless since you can buy TV at the reduced
price. You can let your option expire worthless – have no obligation to exercise it.

Scenario 2: Your friend phoned you and told you that he needs a new TV. You mentioned your rain
check and agreed to sell it to him for £10.
– the option premium is £10, the same strike price of £120 and expiration date of 2 months.
– your friend is taking risk: TV might be cheaper than £120 (rain check is worthless lose £10)
Computational Finance 17/47
 Vanilla Options: Call and Put
Call option – right to buy particular asset for an agreed amount at specified time in future
Put option – right to sell a particular asset for an agreed amount at a specified time in future

Example: Consider a call option on IBM stock which gives the holder the right to buy IBM stock
for an amount of $25 in one month. Today's stock price is $24.5.
amount $25 which we can pay for stock is called exercise or strike price
date on which we must exercise our option, if we decide to, is called expiry or expiration date
stock (IBM ) on which option is based is known as underlying asset
premium is the amount paid for the contract initially
Let’s see what may happen over the next month until expiry!

Case 1: Suppose that nothing happens – stock price remains at $24.5. What do we do at expiry?

- exercise the option, handing over $25 to receive the stock.

- !!!! This is not a sensible decision since the stock is only worth $24.5.
- not exercise option or if really wanted the stock we would buy it in the
stock market for the $24.5.

Case 2: What happens if the stock price rises to $29?

- exercise the option, paying $25 for a stock, worth $29, and get a profit of $4

Computational Finance 18/47

 Example: How do Options Work?
Suppose today is 1st of May. Consider Microsoft (MS) stock
with current price of $67. Premium is $3.15 for a July 70 Call.

 July 70 Call indicates that the expiration is July and strike price is $70 for call

 stock option contract is an option to buy 100 shares–

multiply contract premium by 100 to get total price of 1 call option contract will cost
3.15 x 100 (for the underlying shares) = $315

 strike price of $70 means that the MS stock price must rise above $70 before the
option is worth anything. Since the contract is $3.15 per share, the break-even price
would be $73.15.

Computational Finance 19/47

 Example: how do options work?
May 1st: stock price $67, (< strike price of $70) – we paid $315 for option – theoretically worthless.
But you might not lose the entire $315 because you are allowed to trade the options
contract like a stock as long as it hasn't expired.

3 weeks later, the stock price is $78.

options contract has increased along with the stock price & worth $8.25 x 100 = $825
Profit is ($8.25 - $3.15) x 100 = $510 --- doubled your money in just three weeks.
If you wanted, you could sell your options “closing your position” & take your profits.
If you think the stock price will continue to rise, you can let it ride.
On the expiration date, the MS stock price tanks, and is now $62.
This is less than strike price, and there is no time left option contract is worthless.
 We are now down the original investment $315

Date Stock price Option Contract Gain/Loss

price value ($)
May 1st 67 3.15 0 - 315
May 21st 78 8.25 825 510
Expiry date (July) 62 0 0 - 315
Computational Finance 20/47
 How to Read an Option Table?
1 – Strike price (exercise): the stated price per share for which underlying stock may be
purchased (for a call) or sold (for a put) by the option holder upon
exercise of the option contract.

2 – Expiry Date: shows end of life of options contract.

3 – Call or Put: refers to whether option is call or put.

4 – Volume: the total number of options contracts

traded for the day.

5 – Bid: price which someone is willing to pay for the

options contract.
6 – Ask: price which someone is willing to sell an options contract for.

7 – Open Interest: number of options contracts that are open.

These are contracts which have not expired or have not been exercised.
Total open interest is given at the bottom of the table.

Computational Finance 21/47

 Types of Options
Vanilla Options – simplest ones
Call and Put
 European Options – exercise only at expiry
 American Options – exercise at any time before expiry
 Asian Options – payoff depend on average price of
underlying asset over a certain period of time
 Bermudan options – exercise on specific days,
periods
 Exotic Options –more complex cash flow structures
Barrier, Digital, Lookback so on

Computational Finance 22/47

 Options Valuation
 procedure for assigning a market value to an option
market value of an asset is the value for which it could be sold in the
market today.
– how much is the contract worth now, at expiry, before expiry?
– no idea on stock price is between now & expiry but contract has value
– at least there is no downside to owning option – contract gives you specific
rights but no obligations

 value of contract before expiry depends on 2 things:

– how high asset price is today – the higher asset today the higher we expect
the asset to be at expiry, more valuable we expect a call option
– how long there is before expiry – the longer time to expiry, the more time
for the asset to rise or fall

Computational Finance 23/47

 Payoff Diagram

 value of an option at expiry as function of underlying stock price

 explains what happens at expiry, how much money option contract is worth

•right to buy asset at certain price within specific time •right to sell asset at certain price within specific time
•buyers of calls hope that stock will increase before expiry •buyers of puts hope that stock will decrease before expiry
•buy and then sell amount of stock specified in contract •sell it at a price higher than its current market value

Computational Finance 24/47

 Call Option Value at Expiry

Consider a call option with stock price ST and the exercise price E
at the expiry date T
 Value of a call option is zero or the difference between the value of
the underlying and strike price, whichever is greater.

C  max ST  E ,0 
 If ST  E holder can purchase a share more cheaply in market
than by exercising option
 If ST  E holder receives one share from writer of the call option
for price of E
then make a profit of ST  E

Computational Finance 25/47

 Put Option Value at Expiry

Consider a put option with stock price ST and the exercise

price E at expiry date T
Value of a put option is zero or the difference between
strike price and value of the underlying, whichever is

P  max  E  ST ,0 
greater.

If ST  E holder sells share to the writer of the put

option at price E and makes a profit of E  ST
If ST  E holder prefers not to exercise the option

Computational Finance 26/47

 Example

What are the payoffs of a call and put option at expiry if the exercise
price is £50 and the stock prices are £20, 40, 60, 80?

Stock price Buy Call Write Call Buy Put Write Put
20 Max(20-50,0) = 0 0 Max(50-20,0) = 30 -30
40 0 0 10 -10
60 10 -10 0 0
80 30 -30 0 0

Write an option  Sell an option

Buy call : C  max  ST  E ,0 
Write call : - C   max  ST  E ,0 
Buy put : P  max  E  ST ,0 
Write put : - P   max  E  ST ,0 

Computational Finance 27/47

 Example
Suppose the price of IBM is $666 now. The cost of a 680 call option with
expiry in 3 months is $39. You expect the stock to rise between now and
expiry. How can you profit if your prediction is right?
Suppose that you buy the stock for $666.
Assume that just before expiry, the stock has risen to $730.
Profit is $64 and the investment rises by 730  666
100  9.6%
666
Suppose that you buy the call option for $39.
At expiry, you can exercise the call : pay $680 to receive something
worth $730. You have paid $39 and gain $50.
Profit is $11 per option. In percentage the profit is
value of asset at expiry - strike - cost of call
Profit  100
cost of call
730  680  39
  100  28%
39 Computational Finance 28/47
 Put-Call Parity
Suppose that you buy one European call option with strike price of E and you
write one European put option with the same strike. Both options expire at T
and today’s date is t.
At T, payoff of portfolio of call and put options is sum of individual payoffs.

Computational Finance 29/47

 Put-Call Parity at T
payoff of portfolio of call & put options
max ST  E ,0   max E  ST ,0   ST  E
C  P  ST  E

Type Option Value ST  E ST  E

Call C  max  ST  E , 0  0 ST  E
Option

Put  P   max E  ST , 0   ( E  ST ) 0
Option

Portfolio C-P ST  E ST  E
Value

Computational Finance 30/47

 Put-Call Parity: Before Expiry (t<T)
 If you buy the asset today, then it costs S t worth ST at expiry
 ST uncertain but the amount can be guaranteed by buying the asset
 r (T  t )
 Locking in payment E at T involves a cash flow of E e at t
 A portfolio of a long call and a short put gives same payoff as a long asset
and short cash position
Holding Worth today Worth at Expiry

max ST  E ,0 
Buy Call
C
Continous Compounding
Sell Put
P  max  E  ST ,0  C  P  St  Ee  r (T t )
Buy Stock In general
 St  ST
C  P  St  PV ( E )
Borrow Cash
E e  r (T  t ) E
the same strategies
Total 0
C  P  S t  E e  r (T t ) considered today and at T

Computational Finance 31/47

 Example 1
Suppose that European call and put options on stock A with the same exercise price of £40
and six months to maturity are selling for £5 and £3, respectively. The current stock price is
£40 and the annual interest rate is 8% . Show whether put-call parity is satisfied under annual
compounding? C  5, P  3, E  40, T  0.5, S  40, r  8%
t

1
C  P  St  E
(1  r )T
40
5  3  40   4.51
(1  0.08) 0.5

Put-call parity is not satisfied; the violation might be because of 3 reasons: call option is over-
priced - put option is under-priced - stock is under-priced

Position Initial Value ST<40 ST>40

Arbitrage portfolio
Sell call 5 0 - (ST- 40 )
Buy put -3 40 - ST 0
40(1  0.08) 0.5  38.49
Buy stock - 40 ST ST
Borrow cash 38.49 - 40 - 40
Net portfolio 0.49 0 0
Computational Finance 32/47
 Example 2
Consider a stock, a European put option, a European call option and T-bill.The stock is
currently selling for £100. Both put and call options have maturity of 3 months and the same
exercise price of £90. A call option has a price of £12 and a put £2. The annual interest rate is
5%. Is there an arbitrage opportunity available at these prices under continuous
compounding?
C  12, P  2, E  90, T  0.25, St  100, r  5%
C  P  S t  PV ( E )
PV(E)  Ee  rT
12  2  100  90e 0.050.25  13.12
Put-call parity: Not satisfied; call option is under-priced, put &stock are over-priced
Position Initial Value ST<90 ST>90
Buy call -12 0 ST - 90
Sell put 2 ST-90 0
Sell stock 100 - ST -ST
Buy t-bill -90e-(0.05)0.25 90 90
Net portfolio 1.12 0 0
Computational Finance 33/47
 Option Pricing Models

Approaches to option pricing problem based on different

assumptions about market, dynamics of stock price behaviour
Theories based on the arbitrage principle,
applied when dynamics of underlying stock take certain forms
The simplest of these theories is based on binomial model of
stock price fluctuations
 widely used in practice since it is simple and easy to calculate
 approximation to movement of real prices
 generalizes one period “up-down” model to multi-period setting

Computational Finance 34/47

 Binomial Lattice Model
N trading periods and N+1 trading dates,
invest on a risky security with price of Sn (n=0,1,…,N)
a risk-less bond with annual interest rate of r
If price is known at beginning of period, then price at next period is
one of only two possible values:
– increases with factor of u
– decreases with a factor of d

S n 1  S n H n 1 0  n  N 1
u with probability q
H n 1  
d with probability p
where p  q  1

Computational Finance 35/47

 Single Period Binomial Lattice

Assumptions:
the initial price of the stock is S
up move u with probability q and down move d with probability p ( u > d > 0 )
borrow or lend at risk free interest rate r and R = r+1
Call option on the stock with exercise price E and expiration at the end of period

lattices have common arcs: stock price and value of risk-free loan and value
of call option all move together on a common lattice
 risk free value is deterministic
Computational Finance 36/47
 Risk –Neutral Probability
Based on discounting expected value of option using risk-free rate

For risk-neutral probabilities q and p= 1-q ( 0 < q,p < 1 ) value of one-period call
option on a stock governed by a binomial lattice is found by
taking expected value of option using the probability
discounting this value according to risk – free rate

1
CT 1  E  CT 
R
1 Rd
C   qCu  (1  q )Cd  where q 
R ud
1 uR
C   qCu  pCd  where p  (1  q ) 
R ud
risk neutral formula holds for underlying stock
1
S  quS  (1  q)dS 
R Computational Finance 37/47
 Replicating Portfolio
portfolio (made up of stock and risk free-asset duplicates the outcome of option
Cu and Cd are values of a call option after a single time period.

Cu  max uS  E ,0 and Cd  max dS  E ,0

 purchase ws and wa pounds or dollars worth of stock and risk free asset
 portfolio will have payoffs depending on which path is taken

uws  Rwa or dws  Rwa

Cu  uws  Rwa  Cu  Cd uCd  dCu

Value of portfolio   ws  , wa 
Cd  dws  Rwa  ud R(u  d )

 No-arbitrage rule Cu  Cd uCd  dCu

ws  wa  
ud R (u  d )
1 Rd uR 
C  C u  C d 
R ud ud 
Computational Finance 38/47
 Parameters: Binomial Lattice Model
Inorder to specify the model completely, chose values of u, d and probabilities p, q
such a way that stochastic nature of stock is captured as much as possible
multiplicative in nature and u, d >0 - Stock price never becomes negative
Expected yearly growth rate
  ST 
v  E ln 
  S0 
S 
In deterministic process, exponential growth rate v  ln T   ST  S 0e vT
 S0 
Other parameters
  S 
 2  var ln T 
  S 0 
1 1 v 
q     t ,
2 2  
u  e t
, d  e  t

Binomial model match when period of length is smaller and large number of steps is considered

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 Multi-period Option Pricing

Single period option pricing model can be extended to

multistage option pricing
Find the stock price evaluation through time periods
Find the option values at expiry using the payoff function.
To find option price, use either
Risk Neutral Discounting Method
or
Replicating Portfolio Method

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 Multi-period Option Pricing: Risk Neutral Discounting

Two-stage lattice representing 2-period call option & stock price

 Stock price S is modified by up u and down d factors

 Call option has strike price E & expiration corresponds to final point in lattice
 Starting from the final period and working backward
 Single period risk-free discounting is applied at each node of lattice

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 Multi-period Option Pricing : Risk Neutral Discounting

 At time period 2, the option value

Cuu  max  u 2 S  E ,0 
Cud  max  udS  E ,0 
Cdd  max  d 2 S  E ,0 

Rd uR
 Risk neutral probability q and p  1  q 
ud ud
1 
Cu   qCuu  (1  q)Cud  
R  1
  C   qCu  (1  q)Cd 
1 R
Cd   qCud  (1  q)Cdd  
R 
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 Replicating Portfolio Method

Let V be the option value. x units of stocks and y amount of cash investment

R3 Vuuu
S uuu

Suu R2 Vuu

Su S uud R R3 Vu Vuud

S0 Sud
 1 R2
 V Vud

Sd S udd R R3 Vd Vudd

Sdd R2 Vdd

S ddd R3 Vddd

t=0 t=1 t=2 t=3 t=0 t=1 t=2 t=3 t=0 t=1 t=2 t=3

x y
Su u u x  R 3 y  Vu u u 
  Vuu  S uu x  R 2
y
Su u d x  R y  Vu u d 
3

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 Replicating Portfolio Method
£1cash investment at each node
S uuu R Vuuu

Suu 1 Vuu

Su S uud R R Vu Vuud

S0

Sd
Sud

S udd

1

R
R2

R3
 V

Vd
Vud

Vudd

Sdd 2
R Vdd

S ddd R3 Vddd

t=0 t=1 t=2 t=3

t=0 t=1 t=2 t=3 t=0 t=1 t=2 t=3

x y

Su u u x  Ry  Vu u u 
  Vu u  Su u x  y
Su u d x  Ry  Vu u d 
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 Replicating Portfolio Method
3
Suuu R Vuuu

Suu R2 Vuu

Su Suud R R Vu Vuud

S0 Sud  1 1
 V Vud

Sd Sudd R R Vd Vudd

Sdd R2 Vdd

Sddd R3 Vddd

t=0 t=1 t=2 t=3 t=0 t=1 t=2 t=3 t=0 t=1 t=2 t=3

x y

S u u d x  Ry  Vu u d 
  Vu d  Su d x  y
S u d d x  Ry  Vu d d 
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 Example:Multi-period Binomial Lattice
Consider a stock with a volatility of   0.20 The current price of the stock is £62 pays no
dividends. A call option on this stock has an expiration date 3 months from now and strike
price is £60. Current interest rate is 10% compounded monthly. Determine price of call
option by binomial lattice approach.

Time period length is 1 month Risk Neutral Probabilities

t  1
12 Rd
q  0.5577
u  e t
 1.05943 ud
d  e  t
 0.94390 p  1  0.55770  0.4423

R  1  0.1  1.00833
12

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 Example: continued
Entry at the top node is computed as
1
 0.5577 13.72  0.4423  5.68  10.079
1.00833

Stock Price Evaluation Option Price

max ST  60,0 

      13.7200

    10.0790  
  6.9525   5.6800
4.6075   3.1415  
  1.7375   0.0000
    0.0000  
      0.0000
 t =0 t =1  t =2  t =3 

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