Module 1: Risk-Neutral Valuation in Discrete-time

Recalling Put-Call Parity: Pricing American Options

Call(St , K, T ) − P ut(St , K, T )
Work backwards, step by step; The end-nodes are the
= St e−δ(T −t) − Ke−r(T −t) same as that of European options. Each non end-node
= P
Ft,T − Ke−r(T −t) value Ck is equal to:
= e−r(T −t) [Ft,T − K]
max earlypayoff i , e−rh [p∗ Sk u + (1 − p∗ )Sk d]


Binomial Trees (one period)

Estimating u and d
Given the volatility of the underlying stock σ (the stan-
dard deviation of the stock return) we can calculate u
and d as follows:
Cu − Cd Cu − Cd
∆ = e−δh = e−δh Forward tree:
S0 (u − d) Su − Sd √ √
u = exp{(r−δ)h+σ h}, d = exp{(r−δ)h−σ h}
uCd − dCu Su Cd − Sd Cu
B = e−rh = e−rh √
u−d Su − Sd ⇒ p∗ = (1 + eσ h −1
)
 (r−δ)h
u − e(r−δ)h

e −d Cox-Ross-Rubinstein binomial tree:
C0 = e−rh Cu + Cd √ √
u−d u−d
u = exp{σ h}, d = exp{−σ h}
= e−rh [p∗ Cu + (1 − p∗ )Cd ] = e−rh E∗ [Ch ]
Jarrow-Rudd binomial tree:
p∗ is the risk-neutral probability of an increase in the 1 √
u = exp{(r − δ − σ 2 )h + σ h}
stock price in one step h. 2
1 2 √
e(r−δ)h − d S0 e(r−δ)h − Sd d = exp{(r − δ − σ )h − σ h}
p∗ = = 2
u−d Su − Sd
The stock expected future value under the risk-neutral
measure is the forward price:
Options On Currencies
E∗ (Sh ) = S0 e(r−δ)h It is the same treatment, where δ = rf the foreign cu-
rrency risk free interest rate.
√
The price of the replicating portfolio and the derivati- u = exp{(r − rf )h + σ h};
ve:
√
C0 = ∆S0 + B = e−rh E∗ [Ch ] d = exp{(r − rf )h − σ h}
σ is the volatility of the exchange rate.
Multiperiod Binomial Trees
Call(K, T ) − P ut(K, T ) = x0 e−rf T − Ke−rT ;

C0 = e−rT E∗ [CT ]; T = nh x0 = exchange rate at time t = 0 (dmstc/frng).

For a tree with n steps, there are n+1 end nodes.

Options on Future Contracts
The k th end-node has value S0 uk dn−k ; It is the same treatment with δ = r.
k = 0, 1, ..., n. √ √
u = exp{σ h}, d = exp{−σ h}, p∗ = 1−d
u−d
The risk-neutral probability that the k th end no-
de will be reached is (nk )(p∗ )k (1 − p∗ )n−k Call(k, T ) − P ut(k, T ) = F0 e−rT − ke−rT

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 Module 1: Risk-Neutral Valuation in Discrete-time

Pricing with true probabilities State Prices

Let α be the expected return on a stock in the real Consider a Stock,
world, i.e., E(Sh ) = S0 exp{(α − δ)h}.
H is the security that pays 1 dollar at time h if
the stock price goes up after h years.
e(α−δ)h − d Let QH be the price of H
p=
u−d
L is the security that pays 1 dollar at time h if
is the true probability that the stock price will go up the stock price goes down after h years.
after a time period of h. Let QL be the price of L
Let γ be the appropriate continuously compounded, For any derivative that pays CH in the up state and
annualized discount rate for the option: CL in the down state
S0 ∆ B
⇒ eγh = eαh + erh ⇒ price = QH CH + QL CL
S0 ∆ + B S0 ∆ + B
Then derivative price is To obtain QH , QL we replicate the bond and the pre-
C0 = exp(−γh)[pCu + (1 − p)Cd ] paid forward contract of the stock.
.
QH + QL = e−rh

Using true probabilities to price an option is not SH QH + SL QL = S0 e−δh
useful.
⇒
When extended to multi-period tree, we have to
calculate ∆, B and γ at each node. S0 e−δh − SL e−rh Sh e−rh − S0 e−δh
QH = ; QL =
Unless we are given p and γ values, we shouldn’t SH − SL SH − SL
use the P measure for pricing. Notice that to com-
pute γ, we need to obtain ∆ and B, but if ∆ and Relation between state prices and other valuation met-
B are available, we can calculate de option price hods.
as ∆S0 + B QH
p∗ = QA
; p∗A = QA +Q B +QL
QH + QL
QH = pUH , QL = (1 − p)UL

where UH (UL ) is the utility valve.

pUH
p∗ =
pUH + (1 − p)UL