FIN 4003 Financial Derivatives

Lecture 8

Binomial Trees
Learning Outcomes

After this class, you should be able to

 calculate the value of options using
one-step binomial tree and two-step
binomial tree;
 understand the rationale behind no-
arbitrage principle and risk-neutral
valuation.

2
 A One-Step 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

3
 A Call Option

A 3-month 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

4
Setting Up a Riskless Portfolio
 For a portfolio that is long D shares and
short 1 call option values are
$22D – 1

$18D

 Portfolio is riskless when $22D – 1 = 18D,

or D = 0.25

5
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–0.12×0.25 = 4.3670

6
Valuing the Option
 The portfolio, which has 0.25 shares and 1
short call 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 )

7
The General Case
 The stock price is S0 per share at time 0.
At time T, the price would become uS0 in
the good case, and dS0 in the bad case
(u > 1 and d < 1).
 An option on the stock is traded at ƒ at
time 0. At time T, it would become ƒu in the
good case, and ƒd in the bad case.
 Let r denote the risk-free interest rate.

8
The General Case (continued)
 Consider a portfolio of a long position in ∆
shares and a short position in the option.
The value of the portfolio is:

∆uS0 - ƒu

∆S0 – ƒ
∆dS0 - ƒd

9
Generalization (continued)
 The portfolio is riskless when

ƒu − f d
DS0u – ƒu = DdS0 – ƒd or D=
S 0u − S 0 d

 Value of the portfolio at time T is Du S0 – ƒu

 Value of the portfolio today is (D uS0 – ƒu)e–rT
 Another expression for the portfolio value
today is DS0 – f
 Hence ƒ = DS0 – (D u S0 – ƒu )e–rT
10
Generalization (continued)

 Substituting for D we obtain

ƒ = e–rT[ pƒu + (1 – p)ƒd ]

where
erT − d
p=
u−d

11
p as a Probability
 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
risk-free rate, or in other words, investors
are risk-neutral.
 A world where investors are risk-neutral is
referred to as a risk-neutral world.

12
p as a Probability (continued)
 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 discounted at the risk-free rate in a
risk-neutral world
S 0u
ƒu
S0
ƒ
S 0d
ƒd 13
 Risk-Neutral Valuation
 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
(investors are risk-neutral)
⚫ and discount the future values at the risk-
free rate
 This is known as risk-neutral valuation

14
Original Example Revisited
S0u = 22
ƒu = 1
S0=20
ƒ
S0d = 18
ƒd = 0

 p is the probability that gives a return on the

stock equal to the risk-free rate:
22p + 18(1 – p )=20e 0.12 ×0.25 so that p = 0.6523
 Alternatively: e rT − d e 0.120.25 − 0.9
p= = = 0.6523
u−d 1.1 − 0.9
15
Valuing the Option Using Risk-
Neutral Valuation
S0u = 22
ƒu = 1
S0=20
ƒ
S0d = 18
ƒd = 0

The value of the option is:

e–0.12×0.25 (0.6523×1 + 0.3477×0)

= 0.633
16
 Irrelevance of Stock’s Expected Return
 When we are valuing an option in terms of
the price of the underlying asset,
⚫ the probability of up and down movements
in the real world are irrelevant
⚫ This is an example of a more general result
stating that the expected return on the
underlying asset in the real world is
irrelevant

17
A Two-Step Example
 A stock is traded at $20 per share now
 In the following 6 months, it will either
increase or decrease by 10% every 3
months
 A 6-month call option on the stock has a
strike price K=21
 The risk-free interest rate is r = 12%
 What is the option price?

18
A Two-Step Example (continued)
24.2
D 3.2
B 22
20 A 2.0257 19.8
1.2823 E 0.0
18
C
0.0 16.2
F 0.0
 Apply the one-step binomial tree to nodes
B, D, E.
 The risk-neutral probability p=0.6523.
 The option price at node B is:
e–0.12×0.25(0.6523×3.2 + 0.3477×0) = 2.0257
19
A Two-Step Example (continued)

 Applying the one-step binomial tree of nodes

C, E, F, the option price at node C is $0.0
 Finally, from the binomial tree A-B-C, we can
solve the option price at time 0:

e–0.12×0.25(0.6523×2.0257 + 0.3477×0)
= 1.2823

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 Generalization
 Given the case shown below, we can solve for
all the component one-step binomial trees.
 Hence, 𝑓𝑢 = 𝑒 −𝑟∆𝑡 𝑝𝑓𝑢𝑢 + 1 − 𝑝 𝑓𝑢𝑑 , 𝑓𝑑 = 𝑒 −𝑟∆𝑡 𝑝𝑓𝑢𝑑 + 1 − 𝑝 𝑓𝑑𝑑 ,
𝑟∆𝑡
𝑒 −𝑑
𝑝 = 𝑢−𝑑 , and
 𝑓 = 𝑒 −𝑟∆𝑡 𝑝𝑓𝑢 + 1 − 𝑝 𝑓𝑑 = 𝑒 −2𝑟∆𝑡 𝑝2 𝑓𝑢𝑢 + 2𝑝 1 − 𝑝 𝑓𝑢𝑑 + (1 − 𝑝)2 𝑓𝑑𝑑

u2S0
fuu
uS0
S0 fu udS0
f fud
dS0
fd d2S0
fdd 21
 A 2-year Put Option Example
72
0
60
50 1.4147 48
4.1923 4
40
9.4636 32
20

K = 52, time step ∆t = 1 year

r = 5%, u =1.2, d = 0.8, p = 0.6282

22
What Happens When the Put is
American Option
72
0
60
50 1.4147 48
5.0894 4
40
C
12.0 32
20

 The American feature increases the value

at node C from 9.4636 to 12.0.
 This increases the value of the option from
4.1923 to 5.0894.
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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 shares in the
underlying stock we need to offset the
changes in option prices, i.e. the optimal
hedging ratio for the option.
 It measures how sensitive of the prices
of an option to the changes in the
current price of the underlying stock.
 The value of D varies from node to node. 24
Choosing u and d

 One way of matching the volatility is to

set s Dt
u=e
−s Dt
d =1 u = e

where s is the volatility and Dt is the

length of the time step. This is the
approach used by Cox, Ross, and
Rubinstein.
25
Girsanov’s Theorem

 Volatility is the same in the real world and

the risk-neutral world
 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

26
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

27
The Probability of an Up Move
a−d
p=
u−d

a = e rDt for a nondividend paying stock

a = e ( r − q ) Dt for a stock index where q is the dividend

yield on the index

( r − r ) Dt
a=e f for a currency where r f is the foreign
risk - free rate

a = 1 for a futurescontract
28
The Number of Steps

 To mimic the lognormal distribution

of stock prices, the life of the option
is typically divided into 30 or more
binomial steps.
 We can employ a computer to
enumerate the possible cases in the
final step, and work backward
through the binomial tree.

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