COMP 7570 Computational Finance

12.7 Matching volatility with u and d

Avardeep Singh
Department of Computer Science
University of Manitoba

12.7 Matching Volatility with u and d

We use u and d to match the volatility of the stock price
in a binomial tree
We match the volatility in the real world and risk-neutral
world and shows that it does not matter for small value
of t.

Contd

Contd
For small t and particular value of u and d,
Volatility in real world = volatility in risk-neutral world
S0: Stock price at starting
S0u: Stock price if it moves up
S0d: Stock price if it moves down
p*: Probability of an up movement in real world
p: Probability of an up movement in risk-neutral world

Contd
Expected stock price at the end of the first time in real
world is S0
: expected return
On tree expected stock price at first time is given by
p*S0u + ( 1 - p* ) S0d
Matching expected
parameters, we have
p*S0u + ( 1 - p* ) S0d = S0

return

on

stock

with

trees

Contd

p*=

Eq. 1

Standard deviation of the return on stock price in time

period t is given by
Variance of the stock price return is i.e.
p* + (1 p*) - Eq. 2

contd
Substituting values of Eq.1 in Eq.2 gives,
=
When terms in and higher powers of t are ignored,
one solution to this equation is
u=
d=

Contd
In risk-neutral world the expected price at the end of
time step is S0
the variance of stock price return in risk-neutral world
is
p+(1-p) - = [(u + d) ud - ]
On substituting u= and d=
the above equation equals
ignored

if terms in and t are