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Binomial Option Pricing Model
Binomial Option Pricing Model
Sankarshan Basu
Professor of Finance
Indian Institute of Management Bangalore
Binomial Tree
• Binomial tree is a diagram representing
different paths that might be followed by the
stock price over the life of an option.
• It is assumed that stock price follows random
walk.
• At each time step, there is certain probability of
moving up or down with certain percentage.
• As time step becomes smaller, this model leads
to lognormal assumption of stock prices.
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22∆ – 1
18∆
• Portfolio is riskless when 22D – 1 = 18D or D = 0.25
5
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Generalization
• Notations:
S0 = Stock price
ƒ = Call option price
T = time of option
S0u= up level for stock price where u > 1
ƒu = payoff from option when stock price rises to S0u
S0d = down level for stock price where d < 1
ƒd = payoff from option when stock price goes down to
S0d
Generalization
• The value of a derivative is its expected payoff in a risk-
neutral world discounted at the risk-free rate
S0u
p ƒu
S0
ƒ S0d
1–p
ƒd
e rT d
• ƒ = [ pƒu + (1 – p)ƒd ]e–rT where p
ud
• It is natural to interpret p and 1-p as probabilities of up
and down movements.
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e rT d e 0.12*0.25 0.9
p 0.6523
ud 1 .1 0 .9
• Hence the value of the option is
= e–0.12*0.25 (0.6523*1 + 0.3477*0)
= Rs. 0.633
10
10
Calculation of u and d
u upward movement es Dt
d downward movement 1 u e s Dt
11
11
20 19.8
18
16.2
• Each time step is 3 months
• K=21, r=12%, p =0.6523
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12
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13
14
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15
15
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72
D
0
60
B
50 1.4147 48
A E 4
4.1923
40
C
9.4636 32
F 20
16
16
17
18
18
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Problem No. 1
• A stock price is currently $50. It is known
that at the end of six months it will be
either $60 or $42. The risk-free rate of
interest with continuous compounding is
12% per annum. Calculate the value of a
six-month European call option on the
stock with an exercise price of $48. Verify
that no-arbitrage arguments and risk-
neutral valuation arguments give the same
answers.
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20
21
21
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22
22
23
23
24
24
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25
25
26
26
27
27
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28
28
29
29
30
30
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Problem No. 3
• A stock price is currently $30. During each
2-month period for the next four months it
is expected to increase by 8% or reduce by
10%. The risk-free interest rate is 5%. Use
a two-step tree to calculate the value of a
derivative that pays off [max(30 — ST, 0]2,
where ST is the stock price in 4 months? If
the derivative is American-style, should it
be exercised early?
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32
32
33
33
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34.922
D 0.0
32.4
B
30 0.2785 29.160
A E 0.7056
5.394
27
C
Max (9, 13.2449) 24.3
F 32.49
34
34
12