Lecture 11

Sergei Fedotov

20912 - Introduction to Financial Mathematics

Sergei Fedotov (University of Manchester) 20912 2010 1/7

 Lecture 11

1 American Put Option Pricing on Binomial Tree

2 Replicating Portfolio

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 American Option

• An American Option is one that may be exercised at any time prior to

expire (t = T ).

Sergei Fedotov (University of Manchester) 20912 2010 3/7

 American Option

• An American Option is one that may be exercised at any time prior to

expire (t = T ).

• We should determine when it is best to exercise the option.

• It is not subjective! It can be determined in a systematic way!

Sergei Fedotov (University of Manchester) 20912 2010 3/7

 American Option

• An American Option is one that may be exercised at any time prior to

expire (t = T ).

• We should determine when it is best to exercise the option.

• It is not subjective! It can be determined in a systematic way!

• The American put option value must be greater than or equal to the
payoff function.

If P < max(E − S, 0), then there is obvious arbitrage opportunity.

Sergei Fedotov (University of Manchester) 20912 2010 3/7

 American Option

• An American Option is one that may be exercised at any time prior to

expire (t = T ).

• We should determine when it is best to exercise the option.

• It is not subjective! It can be determined in a systematic way!

• The American put option value must be greater than or equal to the
payoff function.

If P < max(E − S, 0), then there is obvious arbitrage opportunity.

We can buy stock for S and option for P and immediately exercise the
option by selling stock for E .

Sergei Fedotov (University of Manchester) 20912 2010 3/7

 American Option

• An American Option is one that may be exercised at any time prior to

expire (t = T ).

• We should determine when it is best to exercise the option.

• It is not subjective! It can be determined in a systematic way!

• The American put option value must be greater than or equal to the
payoff function.

If P < max(E − S, 0), then there is obvious arbitrage opportunity.

We can buy stock for S and option for P and immediately exercise the
option by selling stock for E .
E − (P + S) > 0

Sergei Fedotov (University of Manchester) 20912 2010 3/7

 American Put Option Pricing on Binomial Tree
We denote by Pnm the n-th possible value of put option at time-step m∆t.

Sergei Fedotov (University of Manchester) 20912 2010 4/7

 American Put Option Pricing on Binomial Tree
We denote by Pnm the n-th possible value of put option at time-step m∆t.

• European Put Option:

Pnm = e −r ∆t pPn+1
m+1
+ (1 − p)Pnm+1 .

e r∆t −d
Here 0 ≤ n ≤ m and the risk-neutral probability p = u−d .

Sergei Fedotov (University of Manchester) 20912 2010 4/7

 American Put Option Pricing on Binomial Tree
We denote by Pnm the n-th possible value of put option at time-step m∆t.

• European Put Option:

Pnm = e −r ∆t pPn+1
m+1
+ (1 − p)Pnm+1 .

e r∆t −d
Here 0 ≤ n ≤ m and the risk-neutral probability p = u−d .

• American Put Option:

n
o
Pnm = max max(E − Snm , 0), e −r ∆t pPn+1
m+1
+ (1 − p)Pnm+1 ,

where Snm is the n-th possible value of stock price at time-step m∆t.

Sergei Fedotov (University of Manchester) 20912 2010 4/7

 American Put Option Pricing on Binomial Tree
We denote by Pnm the n-th possible value of put option at time-step m∆t.

• European Put Option:

Pnm = e −r ∆t pPn+1
m+1
+ (1 − p)Pnm+1 .

e r∆t −d
Here 0 ≤ n ≤ m and the risk-neutral probability p = u−d .

• American Put Option:

n
o
Pnm = max max(E − Snm , 0), e −r ∆t pPn+1
m+1
+ (1 − p)Pnm+1 ,

where Snm is the n-th possible value of stock price at time-step m∆t.

• Final condition: PnN = max E − SnN , 0 , where n = 0, 1, 2, ..., N, E is the

strike price.
Sergei Fedotov (University of Manchester) 20912 2010 4/7
 Example: Evaluation of American Put Option on Two-Step
Tree

We assume that over each of the next two years the stock price either
moves up by 20% or moves down by 20%. The risk-free interest rate is 5%.

Find the value of a 2-year American put with a strike price of $52 on a
stock whose current price is $50.

Sergei Fedotov (University of Manchester) 20912 2010 5/7

 Example: Evaluation of American Put Option on Two-Step
Tree

We assume that over each of the next two years the stock price either
moves up by 20% or moves down by 20%. The risk-free interest rate is 5%.

Find the value of a 2-year American put with a strike price of $52 on a
stock whose current price is $50.

In this case u = 1.2, d = 0.8, r = 0.05, E = 52.

e 0.05 −0.8
Risk-neutral probability: p= 1.2−0.8 = 0.6282

Sergei Fedotov (University of Manchester) 20912 2010 5/7

 Example: Evaluation of American Put Option on Two-Step
Tree

Pu = e −0.05×1 (0.6282 × 0 + 0.3718 × 4) = 1.4147

Sergei Fedotov (University of Manchester) 20912 2010 6/7

 Example: Evaluation of American Put Option on Two-Step
Tree

Pu = e −0.05×1 (0.6282 × 0 + 0.3718 × 4) = 1.4147

Pd = e −0.05×1 (0.6282 × 4 + 0.3718 × 20) = 9.4636

Sergei Fedotov (University of Manchester) 20912 2010 6/7

 Example: Evaluation of American Put Option on Two-Step
Tree

Pu = e −0.05×1 (0.6282 × 0 + 0.3718 × 4) = 1.4147

Pd = e −0.05×1 (0.6282 × 4 + 0.3718 × 20) = 9.4636

Payoff: E − S = 52 − 40 = 12 > 9.4636. Early exercise is optimal!

Pd = 12

Sergei Fedotov (University of Manchester) 20912 2010 6/7

 Example: Evaluation of American Put Option on Two-Step
Tree

Pu = e −0.05×1 (0.6282 × 0 + 0.3718 × 4) = 1.4147

Pd = e −0.05×1 (0.6282 × 4 + 0.3718 × 20) = 9.4636

Payoff: E − S = 52 − 40 = 12 > 9.4636. Early exercise is optimal!

Pd = 12

P0 = e −0.05×1 (0.6282 × 1.4147 + 0.3718 × 12) = 5.0894

Sergei Fedotov (University of Manchester) 20912 2010 6/7

 Example: Evaluation of American Put Option on Two-Step
Tree

Pu = e −0.05×1 (0.6282 × 0 + 0.3718 × 4) = 1.4147

Pd = e −0.05×1 (0.6282 × 4 + 0.3718 × 20) = 9.4636

Payoff: E − S = 52 − 40 = 12 > 9.4636. Early exercise is optimal!

Pd = 12

P0 = e −0.05×1 (0.6282 × 1.4147 + 0.3718 × 12) = 5.0894

Payoff: E − S = 52 − 50 = 2 < 5.0894. Early exercise is not optimal at

the initial node

Sergei Fedotov (University of Manchester) 20912 2010 6/7

 Replicating Portfolio
The aim is to calculate the value of call option C0 .

Let us establish a portfolio of stocks and bonds in such a way that the
payoff of a call option is completely replicated.

Final value: ΠT = CT = max (S − E , 0)

Sergei Fedotov (University of Manchester) 20912 2010 7/7

 Replicating Portfolio
The aim is to calculate the value of call option C0 .

Let us establish a portfolio of stocks and bonds in such a way that the
payoff of a call option is completely replicated.

Final value: ΠT = CT = max (S − E , 0)

To prevent risk-free arbitrage opportunity, the current values should be

identical. We say that the portfolio replicates the option.

The Law of One Price: Πt = Ct .

Sergei Fedotov (University of Manchester) 20912 2010 7/7

 Replicating Portfolio
The aim is to calculate the value of call option C0 .

Let us establish a portfolio of stocks and bonds in such a way that the
payoff of a call option is completely replicated.

Final value: ΠT = CT = max (S − E , 0)

To prevent risk-free arbitrage opportunity, the current values should be

identical. We say that the portfolio replicates the option.

The Law of One Price: Πt = Ct .

Consider replicating portfolio of ∆ shares held long and N bonds held

short.

Sergei Fedotov (University of Manchester) 20912 2010 7/7

 Replicating Portfolio
The aim is to calculate the value of call option C0 .

Let us establish a portfolio of stocks and bonds in such a way that the
payoff of a call option is completely replicated.

Final value: ΠT = CT = max (S − E , 0)

To prevent risk-free arbitrage opportunity, the current values should be

identical. We say that the portfolio replicates the option.

The Law of One Price: Πt = Ct .

Consider replicating portfolio of ∆ shares held long and N bonds held

short.
The value of portfolio: Π = ∆S − NB. A pair (∆, N) is called a trading
strategy.

How to find (∆, N) such that ΠT = CT and Π0 = C0 ?

Sergei Fedotov (University of Manchester) 20912 2010 7/7
 Example: One-Step Binomial Model.

Initial stock price is S0 . The stock price can either move up from S0 to
S0 u or down from S0 to S0 d. At time T , let the option price be Cu if the
stock price moves up, and Cd if the stock price moves down.

Sergei Fedotov (University of Manchester) 20912 2010 8/7

 Example: One-Step Binomial Model.

Initial stock price is S0 . The stock price can either move up from S0 to
S0 u or down from S0 to S0 d. At time T , let the option price be Cu if the
stock price moves up, and Cd if the stock price moves down.

The value of portfolio: Π = ∆S − NB.

When stock moves up: ∆S0 u − NB0 e rT = Cu .

When stock moves down: ∆S0 d − NB0 e rT = Cd .

Sergei Fedotov (University of Manchester) 20912 2010 8/7

 Example: One-Step Binomial Model.

Initial stock price is S0 . The stock price can either move up from S0 to
S0 u or down from S0 to S0 d. At time T , let the option price be Cu if the
stock price moves up, and Cd if the stock price moves down.

The value of portfolio: Π = ∆S − NB.

When stock moves up: ∆S0 u − NB0 e rT = Cu .

When stock moves down: ∆S0 d − NB0 e rT = Cd .

We have two equations for two unknown variables ∆ and N.

Sergei Fedotov (University of Manchester) 20912 2010 8/7

 Example: One-Step Binomial Model.

Initial stock price is S0 . The stock price can either move up from S0 to
S0 u or down from S0 to S0 d. At time T , let the option price be Cu if the
stock price moves up, and Cd if the stock price moves down.

The value of portfolio: Π = ∆S − NB.

When stock moves up: ∆S0 u − NB0 e rT = Cu .

When stock moves down: ∆S0 d − NB0 e rT = Cd .

We have two equations for two unknown variables ∆ and N.

Current value: C0 = ∆S0 − NB0 .

Sergei Fedotov (University of Manchester) 20912 2010 8/7

 Example: One-Step Binomial Model.

Initial stock price is S0 . The stock price can either move up from S0 to
S0 u or down from S0 to S0 d. At time T , let the option price be Cu if the
stock price moves up, and Cd if the stock price moves down.

The value of portfolio: Π = ∆S − NB.

When stock moves up: ∆S0 u − NB0 e rT = Cu .

When stock moves down: ∆S0 d − NB0 e rT = Cd .

We have two equations for two unknown variables ∆ and N.

Current value: C0 = ∆S0 − NB0 .

e rT −d
Prove: C0 = e −rT (pCu + (1 − p)Cd ) , where p = u−d . (Exercise sheet 5)

Sergei Fedotov (University of Manchester) 20912 2010 8/7