Derivatives 2

Part II
Binomial Trees: Basics
Derivatives I
68
Dr. Patrick Konermann
One-Period Binomial Model
5 One-Period Binomial Model

Replicating Portfolio
Risk-Neutral Pricing
Market Completeness
6 Multi-Period Binomial Model
7 American Options
8 Futures
Derivatives I
69
Problem
Example
You want to buy a call option on a stock with maturity in one year
and with a strike price of 105. The current stock price is 100, and
you know that the stock price in one year will have increased by
20% or decreased by 20%. The risk-free interest rate is 5%
(discrete compounding).
What is the value of this option?

(Pricing)
How can you hedge this option?
(Hedging)
Use a binomial tree
Derivatives I
70
One-Period Binomial Model One-Period Binomial Model
Central assumption on stock price behavior

two points in time: t = 0, t = 1
two states at t = 1
up (stock price increases)
down (stock price decreases)
stock price at t = 0: S0
stock price at t = 1 q u
S1 = S0 u
S1u

up-state: = S0 u
down-state: S1d = S0 d S0 qH

H
assumption: u > d
Hq S d = S0 d
HH
q q -1
t=0 t=1
Further assumptions
no transaction costs, no taxes
infinite divisibility
unlimited short selling
Derivatives I
71
Option Pricing: Example (contd)
Stock
S0 = 100, u = 1.2, d = 0.8
S1u = S0 u = 120, u
S1d = S0 d = 80 q S1u = 120
C1 = 15

Option: payment in t = 1 S0 = 100
q

depends on stock price, C0 =?
HH
C1 = max{S1 K , 0} H
Hq
H S1d = 80
up-move C1d = 0
q q-
C1u = max{S1u K , 0} t=0 t=1
= max{120 105, 0}
= 15
down-move
C1d = max{S1d K , 0}
= max{80 105, 0}
= 0
Derivatives I
72
Consider the following portfolio

0.375 shares long
borrow 28.57 at risk-free rate r
t = 0: Portfolio value 0.375 S0 28.57 = 8.93
t = 1: Portfolio value 0.375 S1 28.57 1.05

0.375 120 28.57 1.05 = 15 up
0.375S1 28.571.05 =
0.375 80 28.57 1.05 = 0 down
this is exactly the value of the call option!

Result: portfolio replicates call option
Economic argument: if there are no arbitrage opportunities
value of replicating portfolio today = value of call today
Derivatives I
73
If C0 = 10 (> 8.93 = portfolio value): arbitrage!

t=0 t=1
sell 0.375 shares: +45
repay loan: -30
payoff option: -15
0
buy 0.375 shares: -37.50
borrow money: +28.57
sell option: +10.00
+1.07
sell 0.375 shares: +30
repay loan: -30
payoff option: 0
0
risk-free profit with no initial investment
Derivatives I
74
One-Period Binomial Model Replicating Portfolio
Replicating Portfolio: A portfolio that consists of basis

assets (here: stock, risk-free investment at interest rate r ) and
for which the future value at t = 1 is exactly equal to the
value of the derivative at t = 1.
Central Idea (for pricing)

replicating portfolio and derivative have the same value at
t=1
replicating portfolio and derivative must also have the same
value today
Central Idea (for hedging)

replicating portfolio and derivative have the same value at
t=1
it is possible to hedge a long position in the derivative with a
short position in the replicating portfolio (and vice versa)
Derivatives I
75
How to Determine the Replicating Portfolio
Portfolio: shares, amount B as a risk-free investment

(B > 0: investment at r , B < 0: borrowing of money at r )
Value at t = 1
S1 + B (1 + r )
Condition: value replicating portfolio = value derivative
S0 u + B (1 + r ) = C1u
S0 d + B (1 + r ) = C1d
Replicating portfolio
C1u C1d C1u S0 u

= B=
S0 u S0 d 1+r
Derivatives I
76
Arbitrage and No-Arbitrage
Arbitrage opportunity
positive payment today or
a chance to receive a positive payment tomorrow
without any initial investment and without any risk of a
negative payment tomorrow
Value replicating portfolio 6= value derivative Arbitrage!
replicating portfolio > derivative:
buy derivative, sell replicating portfolio
t = 0: keep positive difference
t = 1: payments in all states are zero
replicating portfolio < derivative:
sell derivative, buy replicating portfolio
t = 0: keep positive difference
t = 1: payments in all states are zero
If there are no arbitrage opportunities, then:

C0 = S0 + B
Derivatives I
77
Pricing via Replicating Portfolio
Value of the derivative

C u S0 u
C0 = S0 + B = S0 + 1
1+r
u

S0 u C
= S0 + 1
1+r 1+r
C1u C1d Cu

S0 u
= S0 + 1
S0 u S0 d 1+r 1+r
C1u C1d 1 + r u Cu
= + 1
ud 1+r 1+r

1 1 + r u + u d u u (1 + r ) d
= C1 + C1
1+r ud ud

1 1 + r d u u (1 + r ) d
= C1 + C1
1+r ud ud
Derivatives I
78
One-Period Binomial Model Risk-Neutral Pricing
Pricing Equation
Value of the derivative (via replicating portfolio)

1 1 + r d u u (1 + r ) d
C0 = C1 + C1
1+r ud ud
In the example:
1+r d 1.05 0.8 u (1 + r )
= = 0.625, = 0.375
ud 1.2 0.8 ud
call price
1
C0 = (0.625 15 + 0.375 0) = 8.93
1.05
1+r d u(1+r )
ud and ud can be interpreted as probabilities
sum is equal to one
positive if u > 1 + r > d
Derivatives I
79
When Does the Constraint u > 1 + r > d Hold?
When does the constraint u > 1 + r > d hold?

Assumption: u > d 1 + r
t = 0: purchase stock on credit (net payment is zero)
t = 1: net payment is
up: S0 u S0 (1 + r ) > 0
down: S0 d S0 (1 + r ) 0
Arbitrage!
Assumption: 1 + r u > d
t = 0: short position in stock, risk-free investment (net
payment is zero)
t = 1: net payment is
up: S0 (1 + r ) S0 u 0
down: S0 (1 + r ) S0 d > 0
Arbitrage!
Derivatives I
80
When Does the Constraint u > 1 + r > d Hold?
Conclusion
there are no arbitrage opportunities
u > 1 + r > d holds
We already know
u > 1 + r > d holds
1+r d u(1+r )
Putting the arguments together
1+r d u(1+r )
This result holds in general (and not just in our example)
Derivatives I
81
Theorem (Risk-Neutral Pricing)

If there are no arbitrage opportunities, the price of every redundant
asset is equal to the expectation under the risk-neutral
probability measure Q of its discounted future payoff

1 u d
Q C1
C0 = qC1 + (1 q) C1 = E .
1+r 1+r
In the binomial model, the risk-neutral probabilities are

1+r d
q= , 1 q.
ud
Theorem (Arbitrage and One-Period Model)

There are no arbitrage opportunities if and only if there exists at
least one risk-neutral probability measure.
Derivatives I
82
Does risk-neutral pricing imply risk-neutral investors?

at first sight: yes...
at second (or third) sight: NO!
main point: q, 1 q are artificial probabilities
(and not the real probabilities)
risk-neutral pricing
. . . is based on replication and no-arbitrage (just another
notation) and so on non-satiated investors
. . . is not based on risk-neutrality
(no assumptions about risk attitude of investors are made)
Risk-neutral pricing is relative pricing
derivative price is determined relative to stock price, interest
rate and dynamics of the stock price. . .
. . . stock price, dynamics of the stock price and interest rate
are given exogenously
Derivatives I
83
Example: Trinomial Model
The current stock price is 100. In one year, the stock price will
have increased by 20%, decreased by 20%, or it will remain
unchanged. The risk-free interest rate is 10% (continuous).
pur S1u = 120

pm
S0 = 100 r

H r S1m = 100
H
HH
pdHHr S1d = 80
Derivatives I
84
Is the market arbitrage-free?

calculate risk-neutral probabilities
solve the following linear system of equations:
pu + pm + pd = 1
pu 120 + pm 100 + pd 80 = 100 e 0.1
problem: the linear system of equations is under-determined

there is no unique solution
general solution:

pu 0.7629 0.5
pm = 0 + 1
pd 0.2371 0.5
pu , pm , pd depend on
Derivatives I
85
Candidate risk-neutral probabilities pu , pm , pd depend on
Case 1 Case 2 Case 3

= 0.2 = 0.4 = 0.8

pu 0.6629 0.5629 0.3629
pm 0.2 0.4 0.8
pd 0.1371 0.0371 0.1629
risk-neutral pu , pm , pd > 0 pu , pm , pd > 0 pd < 0
probabilities? (therefore: no probabilities!)
There exists at least one risk-neutral probability measure

Derivatives I
86
One-Period Binomial Model Market Completeness
Complete Market
Pricing via a replicating portfolio is only possible if such a portfolio

exists.
Definition (Complete Market, Incomplete Market)
The market is complete if there exists a replicating portfolio for
each contingent claim.
The market is incomplete if there is at least one contingent claim
for which no replicating portfolio exists.
Complete market Incomplete market

replicating portfolio exists replicating portfolio exists
for all contingent claims for some contingent claims
Derivatives I
87
Complete Market
Binomial Model: X
two conditions: value of replicating portfolio = value of
derivative (in up- and down-state)
two variables: , B
the system of equations can be solved for all derivatives
if u 6= d
Trinomial Model
three conditions: value of replicating portfolio = value of
derivative (in up-, middle- and down-state)
two variables: , B
the system of equations can be solved for some derivatives,
but not for all
Derivatives I
88
Complete Market
The replicating portfolio exists for all derivatives if the number of

equations (i.e. the number of states) is equal to or smaller than
the number of variables (i.e. the number of securities)
Theorem (Market Completeness in a One-Period Model)

The market is complete if and only if the number of linearly
independent securities is equal to or larger than the number of
states.
Again, there is a relation to the risk-neutral probabilities:

Theorem (Market Completeness in a One-Period Model)
The market is complete if and only if the candidate risk-neutral
probabilities are unique.
Derivatives I
89
Example: Trinomial Model (contd)
Is the market complete?

calculate candidate risk-neutral probabilities
We already know: no unique solution
market is incomplete
We can also show directly that the market is incomplete:
Contingent claim: C1u = 240, C1m = 200, C1d = 160
replicating portfolio: two stocks long
Contingent claim: C1u = 240, C1m = 200, C1d = 200
replicating portfolio: does not exist
however, we can still price the claim
1 u
C1 (0.7629 0.5 ) + C1m + C1d (0.2371 0.5 )

C0 =
1+r
1
= [230.5160 20]
1.1
for 0 0.4742 pu , pm , pd 0
price bounds: C0 (200.9382; 209.5600)
Derivatives I
90
Literature
Basics
Hull: Options, Futures, and Other Derivatives, Prentice Hall,
8th edition, 2012, Chapters 12.1 - 12.2
Branger/Schlag: Zinsderivate: Modelle und Bewertung,
Springer, 2004, Chapter 3.1
Further Reading
Shreve: Stochastic Calculus for Finance I, Springer, 2005,
Chapter 1.1
Trautmann: Investitionen: Bewertung, Auswahl und
Risikomanagement, Springer, 2007, Chapter 10.1
Questions and Problems
8th edition, 2012, Problems 12.1, 12.2, 12.4, 12.9, 12.10,
12.11, 12.14
Derivatives I
91
Multi-Period Binomial Model

Backward Calculation in Binomial Tree
Choice of Model Parameters
Properties of Option Prices
7 American Options
8 Futures
Derivatives I
92
Multi-Period Binomial Model Multi-Period Binomial Model

= sequence of one-period binomial models
Points in time: t = 0, 1, 2, 3, 4, . . .
Uncertainty: each state at t is followed by two states at t + 1
(up or down)
Development of stock price from t to t + 1:

St u up
St+1 =
St d down
Derivatives I
93
S22 = S0 u 2
S11 = S0 u
S0 S21 = S0 u d
S10 = S0 d
S20 = S0 d 2
t=0 t=1 t=2

Derivatives I
94
Example
Example
S0 = 100, u = 1.2, d = 0.8, r = 0.05. A call option (long) with
strike K = 105 matures at T = 2. What is the value C0 of this
call?
Derivatives I
95
Example
S22 = 144
C22 = 39
S11 = 120
C11 =?
S0 = 100 S21 = 96
C0 =? C21 = 0
S10 = 80
C10 =?
S20 = 64
C20 = 0
t=0 t=1 t=2

Derivatives I
96
Multi-Period Binomial Model Backward Calculation in Binomial Tree
Replication: Backward Calculation in Binomial Tree
Replicating portfolio
payoffs of replicating portfolio and contingent claim coincide at
every point in time and in every state
value of replicating portfolio = value of contingent claim
Replicating portfolio is determined by backward induction

at t = T 1: replication of the payment at T
(for every state at T 1, we have to solve for portfolio weights which will
in general depend on this state)
derivative value at T 1 (in every node)
at t = T 2: replication of the value at T 1
(for every state at T 2, we have to solve for portfolio weights which will
in general depend on this state)
derivative value at T 2 (in every node)
...
at t = 0: replication of the value at t = 1
derivative value at 0
Derivatives I
97
Replication: Example
Solution (Replication)
C22 C21 C22 11 S22
Node t = 1 up: 11 = S22 S21
= 0.8125, B11 = 1+r
= 74.2857
C11 = S11 11 + B11 = 23.2143

C21 C20 C21 01 S21
Node t = 1 down: 01 = S21 S20
= 0, B10 = 1+r
=0
C10 = S10 01 + B10 = 0

C11 C10 C11 0 S11
Node t = 0: 0 = S11 S10
= 0.5804, B0 = 1+r
= 44.2226
C0 = S0 0 + B0 = 13.82
Derivatives I
98
Replication: Example
S22 = 144
C22 = 39
S11 = 120
C11 = 23.2143
11 = 0.8125
S0 = 100 B11 = 74.2857
C0 = 13.82 S21 = 96
0 = 0.5804 C21 = 0
B0 = 44.2226 S10 = 80
C10 = 0
01 = 0
B10 = 0
S20 = 64
C20 = 0
t=0 t=1 t=2

Derivatives I
99
Risk-Neutral Valuation
Risk-Neutral Valuation: backward calculation in binomial

tree
at T 1: value follows from payment at T

CT
CT 1 = E Q |FT 1
1+r
(. . . |FT 1 means: conditional on the state at time T 1)
at T 2: value follows from value at T 1

CT 1
CT 2 = E Q |FT 2
1+r
...
at t = 0: value follows from value at t = 1

Q C1
C0 = E |F0
1+r
Derivatives I
100
Risk-Neutral Valuation: Example
Solution (Risk-Neutral Valuation)

d
artificial probabilities: q = 1+r
ud = 0.625
Node t = 1 up:
1 h 2 i
C11 = qC2 + (1 q)C21
1+r
1
23.2143 = [0.625 39 + 0.375 0]
1.05
Node t = 1 down:
1 h 1 i
C10 = qC2 + (1 q)C20
1+r
1
0 = [0.625 0 + 0.375 0]
1.05
Node t = 0:
1 h 1 i
C0 = qC1 + (1 q)C10
1+r
1
13.8180 = [0.625 23.2143 + 0.375 0]
1.05
Derivatives I
101
To calculate the value at t = 0, there is a shortcut:

Q C1
C0 = E |F0
1+r

Q 1 Q C2
= E E |F1 |F0
1+r 1+r

Q Q C2
= E E |F1 |F0
(1 + r )2

C2
= EQ |F 0
(1 + r )2
Note: we have used the Law of Iterated Expectations:

E [ E [Y |Ft+k ] | Ft ] = E [Y |Ft ], k 0
Derivatives I
102
In our example
C22 C21 C20

C0 = q 2 + 2q(1 q) + (1 q) 2
(1 + r )2 (1 + r )2 (1 + r )2
39 0 0
= 0.6252 + 2 0.625 0.375 + 0.3752
1.052 1.052 1.052
= 13.8180
Derivatives I
103
Theorem (Risk-Neutral Valuation)

If there are no arbitrage opportunities, the price of a contingent
claim is equal to the risk-neutral expectation of the future
discounted payoff:

Q CT
C0 = E |F0 .
(1 + r )T
In case of the binomial model, the risk-neutral probabilities for an

upward movement and a downward movement are
1+r d
q= , and 1 q.
ud
Derivatives I
104
Risk-neutral valuation can also be used to give a relation

between the values at t and at t + s:

Ct+s
Ct = E Q |F t
(1 + r )s
This can be rewritten as

Ct Q Ct+s
= E |Ft
(1 + r )t (1 + r )t+s
In mathematical finance:
discounted derivative prices are Q-martingales
(i.e. the expected future value is equal to the value today, or, stated differently,
the process does on average neither increase nor decrease)
Derivatives I
105
Q-Martingale
Derivative prices normalized with the money market account

are Q-martingales
Money Market Account (MMA): results from rolling
investment at risk-free interest rate
B0 = 1, B1 = (1 + r ), . . . , Bt = (1 + r )t , . . .
Martingale: stochastic process for which the expected future

value is equal to the current value
Application of martingales in option pricing theory:
under the risk-neutral measure Q . . .
discounted stock prices grow on average with 0
stock prices grow on average with r
and: futures prices grow on average with 0
(will be shown later on)
Derivatives I
106
Equivalent Martingale Measure
Instead of the money market account, any other security

(which does not pay any dividends and always has a positive
price) can be used to normalize derivative prices
Numeraire Asset: asset used to normalize prices
Equivalent Martingale Measure: a probability measure
under which
the prices of all assets, normalized with the numeraire, are
martingales
(equivalent martingale measure depends on the numeraire: if we use
a different numeraire, we have of course to use a different
equivalent martingale measure!)
the set of future possible states does not change (only their
probabilities are different)
Derivatives I
107
Multi-Period Binomial Model Choice of Model Parameters
Length of Time Interval
So far: t = 1 In general: t
assumption until now: assumption from now on:
length of time interval is 1 length of time interval is t
the interval from 0 to T is the interval from 0 to T is
divided into T steps divided into T /t steps
1
discounting with 1+r discounting with (1+r1 )t
(discrete interest rate) or (discrete interest rate) or
e r (continuous interest e r t (continuous interest
rate) rate)
u and d determine stock the smaller t the closer u
price uncertainty and d are to e r t
Derivatives I
108
Determining u and d
Determine: u, d and the artificial probabilities q, 1 q

match uncertainty of stock price: volatility is

Q St
Var = q(1 q)(u d)2
S0
!
= 2 t
correct pricing of stock:

Q St
E = qu + (1 q)d
S0
!
= e r t
Derivatives I
109
Determining u and d
Two equations for three unknown variables

different additional assumptions
Assumption: u = d1 (will always be used in this lecture)
approximate solution

u = e t
, d = e t
e r t d ue r t
risk-neutral probabilities: q = ud , 1q = ud
Assumption: q 0.5
approximate solution
2
2

u = e (r /2)t+ t
, d = e (r /2)t t
e r t d ue r t
risk-neutral probabilities: q = ud , 1q = ud
Derivatives I
110
Example
Example
The risk-free interest rate is r = 0.05. The volatility of the stock
price is = 0.4.
t 1.0000 0.5000 0.2500 0.1250 0.0625

assumption: u = d1
u 1.4918 1.3269 1.2214 1.1519 1.1052
d 0.6703 0.7536 0.8187 0.8681 0.9048
q 0.4637 0.4739 0.4814 0.4868 0.4906
assumption: q 0.5
u 1.4477 1.3071 1.2123 1.1476 1.1031
d 0.6505 0.7424 0.8126 0.8649 0.9031
q 0.5027 0.5009 0.5003 0.5001 0.5000
Derivatives I
111
Dependence on Number of Steps
Price of a call option on the stock (current stock price: 100) with
maturity in one year and strike price 100?
option price
number of steps
Derivatives I
112
Multi-Period Binomial Model Properties of Option Prices
Sensitivity Analysis for Option Prices
Assumptions:
stock pays no dividends
options are European
Call Price Put Price

Stock Price (S0 ) + -
Strike Price (K ) - +
Volatility () + +
Time to Maturity (T t) + +/-
Interest Rate (r ) + -
parameters for base case: S0 = K = 100, = 0.4, T = 1,

t = 1/50, and r = 0.05
Derivatives I
113
Impact of Strike Price
option price
option price
strike strike
The higher the strike price

the smaller the future payoff of a call
the larger the future payoff of a put
Derivatives I
114
Impact of Volatility
option price
option price
volatility volatility
The higher the volatility, the higher . . .

the probability of very high stock prices (high call payoff)
the probability of very low stock prices (high put payoff)
Derivatives I
115
Impact of Time to Maturity
option price
option price
time to maturity time to maturity
The longer the time to maturity

the higher the probability of very large stock price changes
the lower the discounted strike price
Derivatives I
116
Impact of Interest Rate
option price
option price
interest rate interest rate
The higher the interest rate

the lower the discounted strike price
the higher future stock prices (under Q)
Derivatives I
117
Literature
Basics
8th edition, 2012, Chapters 12.3 - 12.4, 12.7 - 12.8
Branger/Schlag: Zinsderivate: Modelle und Bewertung,
Springer, 2004, Chapter 3.2
Further Reading
Clewlow/Strickland: Implementing Derivatives Models, Wiley,
1998, Chapter 2.1 - 2.3
Chapter 1.2
Trautmann: Investitionen: Bewertung, Auswahl und
Risikomanagement, Springer, 2007, Chapter 10.3
8th edition, 2012, Problems 12.5, 12.6, 12.7, 12.8, 12.12
Derivatives I
118
American Options
7 American Options
Valuation of American Options
Early Exercise of American Options
Blacks Approximation for American Options
8 Futures
Derivatives I
119
American Options Valuation of American Options
American Options
Remember
European Options: can only be exercised at maturity
American Options: can be exercised up to maturity
Optimal Exercise Strategy
European Options
exercise at time T if option is ITM
binomial tree: test at the final nodes at T whether to exercise
or not
American Options
exercise at time if option is far enough ITM
binomial tree: test at each node from T to 0 whether to
exercise or not
Derivatives I
120
American Call, American Put
Model: S0 = 100, u = 1.2, d = 0.8, r = 0.05 (discrete

interest rate), interval length t = 1
American put expiring at T = 2 with strike price 105
determine the value of the put
determine the optimal exercise strategy
American call expiring at T = 2 with strike price 105
determine the value of the call
determine the optimal exercise strategy
Derivatives I
121
American Put
S22 = 144
payment: 39
do not exercise
S11 = 120
payment: 15
do not exercise
S0 = 100 S21 = 96
payment: 5 payment: 9
??? exercise
S10 = 80
payment: 25
???
S20 = 64
payment: 41
exercise
t=0 t=1 t=2
Derivatives I
122
Valuation of American Options
Pricing an American option: backward induction in the tree

At each node in the binomial tree, we have to test whether
early exercise is optimal or not.
At time t
value of the option if it is hold for one more period

alive Q Ct+1
Ct =E |Ft
1+r
payoff in case of exercise
Ctexercise
Option Value at t: maximum of the two values
Cta = max Ctalive , Ctexercise

Derivatives I
123
Example: Valuation of American Options
Solution
d
risk-neutral probabilities: q = 1+r
ud = 0.625
Node t = 1 up:

P2 1 2
P11 alive = E Q qP2 + (1 q)P21 = 3.2143

|F1 =
1+r 1+r
P11 exercise = max{K S11 , 0} = 0
n o
P11 = max P11 alive , P11 exercise = P11 alive = 3.2143
Node t = 1 down:

P2 1 1
P10 alive = E Q qP2 + (1 q)P20 = 20

|F1 =
1+r 1+r
P10 exercise = max{K S10 , 0} = 25
P10 = max P10 alive , P10 exercise = P10 exercise = 25

Derivatives I
124
Example: Valuation of American Options
Node t = 0:

P1 1 1
P0alive qP1 + (1 q)P10 = 10.8418
Q

=E |F0 =
1+r 1+r
P0exercise = max{K S0 , 0} = 5
P0 = max P0alive , P0exercise = P0alive = 10.8418

Value of the American put: 10.8418.

(for comparison: the value of the European put is 9.0561)
Derivatives I
125
American Put
S22 = 144
P2exercise = 0
S11 = 120 do not exercise
P1exercise = 0
P0alive = 3.21
S0 = 100
P0exercise = 5
do not exercise S21 = 96
P2exercise = 9
P0alive = 10.84
do not exercise S10 = 80 exercise
P1exercise = 25
P0alive = 20
exercise S20 = 64
P2exercise = 41
exercise
t=0 t=1 t=2

Derivatives I
126
And Now: American Call
S22 = 144
C2exercise = 39
S11 = 120 exercise
C1exercise = 15
C0alive = 23.21
S0 = 100
C0exercise = 0
C2exercise = 0
C0alive = 13.82
do not exercise S10 = 80 do not exercise
C1exercise = 0
C0alive = 0
C2exercise = 0
do not exercise
t=0 t=1 t=2

Derivatives I
127
American Options Early Exercise of American Options
Call on Underlying that Pays no Dividends
Theorem (American Call on Underlying that Pays no Dividends)

If the underlying pays no dividends and if the interest rate is
positive, it is never optimal to exercise an American call before
maturity.
Proof:
The value of the American call is at least as high as the value
of the corresponding European call.
Value of the European call:
Cte max{St Ke r (T t) , 0}
St Ke r (T t)
St K
Put together: value of the American call exercise payoff

Derivatives I
128
Call on Underlying that Pays no Dividends
Economic intuition: if the American call is not exercised . . .
the strike price is paid later +

the stock is received later
asymmetric payoff profile +
high stock prices: profit
low stock prices: losses are capped
There is no argument in favor of early exercise!
Derivatives I
129
Put on Underlying that Pays no Dividends
Theorem (American Put on Underlying that Pays no Dividends)

If the underlying pays no dividends and if the interest rate is
positive, it may be optimal to exercise an American put before
maturity.
Proof:
The value of the American put alive is at least as high as the
value of the corresponding European put.
Value of the European put:
Pte max{Ke r (T t) St , 0}
Ke r (T t) St
K St
So: Value of the American put Q exercise payoff
Derivatives I
130
Put on Underlying that Pays no Dividends
Economic Intuition: if the American put is not exercised . . .

the strike price is received later
the stock is sold later
asymmetric payoff profile +
low stock prices: profit
high stock prices: losses are capped
The first argument speaks in favor of early exercise!
Investor waits if the potential profit from future decreases or
the stock price is high
. . . and will thus exercise the put if the stock price is very low
(and cannot fall by much more therefore)
Derivatives I
131
American Options Blacks Approximation for American Options
Theorem (Blacks Approximation for American Options)

Blacks Approximation gives a lower bound for the value of an
American option:
C0a max{C0e (t1 ), C0e (t2 ), . . . , C0e (tn )}
where C0e (ti ) is the price of a European option with maturity date
ti (0 t1 < t2 < . . . < tn T ) and the same strike price as the
American option.
Derivatives I
132
American Option European Option

(expires at T ) (expires at ti T )
long can exercise at any time until T long can only exercise at ti
long can commit himself to exercise only at ti
. . . he then basically holds a European option
. . . but has given up some rights
Conclusion:
C0a (T ) C0e (ti )
Blacks Approximation:
uses several European options with different times to maturity
Derivatives I
133
Literature
Basics
8th edition, 2012, Chapters 10.5-10.6, 12.5
Further Reading
Cox/Ross/Rubinstein: Option pricing: A Simplified Approach,
Journal of Financial Economics 7, 229-263, 1979
Chapter 4.1 - 4.2
8th edition, 2012, Problems 10.4, 10.5, 10.6, 10.8, 10.13, 20.2,
20.10
Derivatives I
134
Futures
7 American Options
8 Futures
Futures Price
Futures Price vs Forward Price
Derivatives I
135
Futures Futures Price
Determination of Futures Price
Remember:
futures = forward + . . .
settlement-payment at time t (long position)
FtT Ft1
T
FtT : futures price at t (T is maturity date)

convention: futures price is set such that futures value
immediately after each settlement-payment is zero
at maturity: FTT = ST
(by definition of contract)
Now: calculation of futures price
Derivatives I
136
Consider the following trading strategy

at t: buy futures contract (after the settlement-payment)
at t + 1: sell futures contract (after the settlement-payment)
Resulting cash flows
at time t at time t + 1
- futures value: 0 T FT
settlement-payment: Ft+1 t
futures value: 0
Plugging into the risk-neutral pricing equation:
" #
F T FT + 0
t
0 = E Q t+1 Ft

1+r
Derivatives I
137
Interest rate at t is known

1 h
T
i
0 = E Q Ft+1 FtT |Ft
1+r
Solve for FtT :
h i
FtT T
= E Q Ft+1 |Ft
The futures price today is equal to the risk-neutral
expectation of the futures price tomorrow!
Again, we can use a shortcut:
h h i i
FtT = E Q E Q Ft+2 T
|Ft+1 |Ft
h i
T
= E Q Ft+2 |Ft
= ... h i
= E Q FTT |Ft = E Q [ST |Ft ]
Derivatives I
138
Theorem (Futures Price)

The futures price is a martingale under the risk-neutral measure
Q: h i
FtT = E Q Ft+s
T
|Ft 0t t +s T
With the terminal condition FTT = ST , this gives
FtT = E Q [ST |Ft ] .
Derivatives I
139
Example
Model: S0 = 100, u = 1.2, d = 0.8, r = 0.05 (discrete

interest rate), interval length t = 1
Consider a futures contract on the stock that matures at time
T = 2.
determine the futures price in every node
calculate the payments of the future
calculate the value of the futures contract in every node
Derivatives I
140
Example: Futures Prices
S22 = 144
F22 = 144
S11 = 120
F11 = 126
S0 = 100 S21 = 96
F0 = 110.25 F21 = 96
S10 = 80
F10 = 84
S20 = 64
F20 = 64
t=0 t=1 t=2
Derivatives I
141
Example: Settlement-Payments
S22 = 144
F22 = 144
F22 F11 = 18
S11 = 120 S21 = 96

F11 = 126 F21 = 96
F11 F0 = 15.75 F21 F11 = 30
S0 = 100
F0 = 110.25
0
S10 = 80 S21 = 96
F10 = 84 F21 = 96
F10 F0 = 26.25 F21 F10 = 12
S20 = 64
F20 = 64
F20 F10 = 20
t=0 t=1 t=2

Derivatives I
142
Futures Futures Price vs Forward Price
Comparison of Futures and Forward Prices
The stock price satisfies the following equation:

ST ST
S0 = E Q = EQ ,
(1 + r )T BT
BT = (1 + r )T : money market account
Using the formula for the covariance

1 1
S0 = E Q [ST ] E Q + Cov Q ST ,
BT BT

1
= E Q [ST ] B0 (T ) + Cov Q ST ,
BT
B0 (T ): price at 0 of a zero-coupon bond that matures at T
This gives

S0 1 1
= E Q [ST ] + Cov Q ST ,
B0 (T ) | {z } B0 (T ) BT
| {z } Futures Price
Forward Price
Derivatives I
143
Comparison of Futures and Forward Prices
h i
1
Futures Price > Forward Price Cov Q ST , (1+r )T
<0
positive correlation between underlying and risk-free interest
rate
remember (from slide 65): long invests at a high interest rate
and borrows at a low interest rate
futures price is higher to offset this advantage
h i
1
Futures Price < Forward Price Cov Q
ST , (1+r )T
>0
negative correlation between underlying and risk-free interest
rate
remember (from slide 66): long invests at a low interest rate
and borrows at a high interest rate
futures price is smaller to offset this disadvantage
h i
1
Forward Price = Futures Price Cov Q ST , (1+r ) T =0
underlying and risk-free interest rate are uncorrelated
(special case: interest rates are deterministic)
Derivatives I
144
Literature
Basics
8th edition, 2012, Chapters 5.8, 17.6
8th edition, 2012, Problems 5.4, 5.11, 5.12, 17.3
Derivatives I
145

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Part II

Binomial Trees: Basics

5 One-Period Binomial Model

6 Multi-Period Binomial Model

What is the value of this option?

Use a binomial tree

Central assumption on stock price behavior

Consider the following portfolio

this is exactly the value of the call option!

If C0 = 10 (> 8.93 = portfolio value): arbitrage!

Replicating Portfolio: A portfolio that consists of basis

Central Idea (for pricing)

Central Idea (for hedging)

How to Determine the Replicating Portfolio

Portfolio: shares, amount B as a risk-free investment

C1u C1d C1u S0 u

Arbitrage and No-Arbitrage

If there are no arbitrage opportunities, then:

Pricing via Replicating Portfolio

Value of the derivative

Value of the derivative (via replicating portfolio)

When Does the Constraint u > 1 + r > d Hold?

When does the constraint u > 1 + r > d hold?

When Does the Constraint u > 1 + r > d Hold?

Theorem (Risk-Neutral Pricing)

In the binomial model, the risk-neutral probabilities are

Theorem (Arbitrage and One-Period Model)

Does risk-neutral pricing imply risk-neutral investors?

Example: Trinomial Model

pur S1u = 120

Example: Trinomial Model

Is the market arbitrage-free?

problem: the linear system of equations is under-determined

Example: Trinomial Model

Candidate risk-neutral probabilities pu , pm , pd depend on

Case 1 Case 2 Case 3

There exists at least one risk-neutral probability measure

Pricing via a replicating portfolio is only possible if such a portfolio

Complete market Incomplete market

The replicating portfolio exists for all derivatives if the number of

Theorem (Market Completeness in a One-Period Model)

Again, there is a relation to the risk-neutral probabilities:

Example: Trinomial Model (contd)

Is the market complete?

5 One-Period Binomial Model

6 Multi-Period Binomial Model

Multi-Period Binomial Model

t=0 t=1 t=2

t=0 t=1 t=2

Replicating portfolio is determined by backward induction

C11 = S11 11 + B11 = 23.2143

C10 = S10 01 + B10 = 0

t=0 t=1 t=2

Risk-Neutral Valuation: backward calculation in binomial

Solution (Risk-Neutral Valuation)

To calculate the value at t = 0, there is a shortcut:

Note: we have used the Law of Iterated Expectations:

C22 C21 C20

Theorem (Risk-Neutral Valuation)

In case of the binomial model, the risk-neutral probabilities for an

Risk-neutral valuation can also be used to give a relation

This can be rewritten as

Derivative prices normalized with the money market account

pur S1u = 120