Lecture 9

Two Step Binomial Trees

9.1 Risk Neutral Valuation

In the last lecture we derived the value of the Call option price as

C0 = e−rT (pCu + (1 − p)Cd ) ,

where
erT − d
p=
u−d
This formula is known as a risk-neutral valuation.

Example 9.1. Show that in order for the No-Arbitrage to hold in a one step binomial tree
model we require
d < erT < u (9.1)

and hence
0 ≤ p ≤ 1. (9.2)

Solution 9.1.

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 Given that (9.1) holds, we can interpret the variable 0 ≤ p ≤ 1 as a probability of an up
movement in the stock price. The probability of up q or down movement 1 − q in the stock price
plays no role whatsoever! Why???
Let us find the expected stock price under the risk neutral probabilities at t = T :

erT − d erT − d
Ep [ST ] = pS0 u + (1 − p)S0 d = S0 u + (1 − )S0 d = S0 erT .
u−d u−d
This shows that stock price grows on average at the risk-free interest rate r. Since the
expected return is r, this is a risk-neutral world.

In the Real World: In a Risk-Neutral World:

µT
E [ST ] = S0 e Ep [ST ] = S0 erT

Example 9.2. What is a Risk-Neutral World?

Solution 9.2.

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 We have our Risk-Neutral valuation formula,

C0 = e−rT Ep [CT ] (9.3)

This formula can is the expected payoff in a risk-neutral world (at maturity), discounted at
risk-free rate r. It is taking the expectations under the risk-neutral measure which allows us to
ignore risk and discount at the risk-free rate to derive a single price for the option.

9.2 Two Step Tree

Now the stock price changes twice, each time by either a factor of u > 1 or d < 1. We assume
that the length of the time step is ∆t such that T = 2∆t. After two time steps the stock price
will be S0 u2 , S0 ud or S0 d2 .

Example 9.3. Draw the two step tree for stock prices.

Solution 9.3.

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 The call option expires after two time steps producing payoffs Cuu , Cud and Cdd respectively.

Example 9.4. Write down formula for Cuu , Cud and Cdd in terms of S0 , E, u and d.

Solution 9.4.

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Example 9.5. Draw and annotate the two step tree for option prices.

Solution 9.5.

The purpose is to calculate the option price C0 at the initial node of the tree. Before we can
find C0 we must apply the risk-neutral valuation backwards in time by first finding Cu and Cd .
We simply use the one step formula to price the option at these nodes to obtain

Cu = e−r∆t (pCuu + (1 − p)Cud )

and
Cd = e−r∆t (pCud + (1 − p)Cdd ) .

Then the final step is to use a one step tree for the current option price

C0 = e−r∆t (pCu + (1 − p)Cd ) .

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Example 9.6. Substitution gives

C0 = e−2r∆t p2 Cuu + 2p(1 − p)Cud + (1 − p)2 Cdd ,

(9.4)

for the option price. What do p2 , 2p(1 − p) and (1 − p)2 represent?

Solution 9.6.

Finally, the current call option price is

C0 = e−rT Ep [CT ] , T = 2∆t.

The current put option price can be found in the same way:

P0 = e−2r∆t p2 Puu + 2p(1 − p)Pud + (1 − p)2 Pdd

(9.5)

or
P0 = e−rT Ep [PT ] .

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Example 9.7. Consider six months European put with a strike price of £32 on a stock with
current price £40. There are two time steps and in each time step the stock price either moves
up by 20% or moves down by 20%. Risk-free interest rate is 10%. Find the current option price.

Solution 9.7.

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