MAL 717

Fuzzy Sets and Applications

Paper overview
A Multiperiod Binomial Model for Pricing Options in a
Vague World
by
Silvia Muzzioli and Costanza Torricelli

Submitted by

Achal Premi (2005MT50558)

Sameer Jain (2005MT50445)
Department of Mathematics
IIT Delhi
Contents
S. No. Titles Page Nos.
1. Introduction 3
1.1 Options 3
1.2 Options Pricing 4
2 Fuzzy Binomial Option Pricing Model 4
(FBOPM)
2.1 Fuzzy Binomial Tree 4
2.2 Risk Neutral Probability Intervals 6
2.3 Pricing of an option in a vague world – Single 11
Period Model
2.4 Multi Period Model 13
3 Defuzzification 15
4 Proposed Extension 15
4.1 Integration of fuzzy BOPM into fuzzy logic 15
4.2 Justification for values of control parameter f 17
4.3 Pattern Recognition & Similarity Measures 17
5 Conclusion 18

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1. Introduction
This paper gives an overview of the “Binomial Option Pricing Model in a
vague world” published by Silvia Muzzioli, Costanza Torricelli in the
“Journal of Economic Dynamics & Control 28 (2004)” and provides an
extension to the model proposed by integrating the fuzzy pricing model
with fuzzy logic rules and pattern recognition to capture the information
about different states of an economy in calculating the price of an option.

1.1. Options
an option is a contract that gives someone the right to buy or sell an
asset for a specified time at a specified price, but unlike a forward or a
future contract, the buyer of the option is not under any obligation to
exercise the option. The asset can be a real asset such as real estate,
agricultural products or natural resources, or it can be a financial asset
such as stock, bond, stock index, foreign currency, etc. There are two
types of options, namely, call and put options

Call Option: The buyer of a call option has the right but not the
obligation to buy an agreed quantity of an asset (the underlying security)
from the seller (writer) of the option at a certain time (the expiration
date) for a certain price (Strike price). The seller is obligated to sell the
asset if the buyer wishes to exercise his right. Initially, the buyer of the
option has to pay a certain amount to the seller for purchasing the option
which is called the premium or the call price. Given below are the payoff
and profit curves for the buyer and seller of a call option.

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 FROM BUYER'S PERSPECTIVE FROM SELLER'S
PERSPECTIVE

Put Option: The buyer of a put option has the right but not the
obligation to sell an agreed quantity of an asset (the underlying security)
to the seller (writer) of the option at a certain time (the expiration date)
at a certain price (Strike price). The seller is obligated to buy the asset if
the buyer wishes to exercise his right. Given below are the payoff and
profit curves for the buyer and seller of a put option

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 FROM BUYER'S PERSPECTIVE FROM SELLER'S
PERSPECTIVE

1.2. Option Pricing

Option pricing is an attempt to determine the “fair” market value of the
premium that should be paid by the buyer to the seller of the option.
(Here the term “fair” refers to a desirable condition that both buyer and
seller should have equal “expected returns” from the option contract).
The aim is to develop a model that takes into account as much market
information as possible and come up with a “fair” value for the option
price (call price or put price).

The different models differ in their ability to cover different aspects of the
market. Thus, a model can be considered to be good if it can take account
of the future movements of underlying security with some precision and
hence determine a “fair” premium value payable at the time of buying
the option.

2. Fuzzy Binomial Options pricing model

(FBOPM)
2.1. Fuzzy Binomial Tree
let us consider a one period model where t ε {0, 1} is the time. Let P0 be
the price of the stock at time t = 0 and P1 be the price at time t = 1, u &
d be the up and down jump factors with the probabilities p and (1-p); p ε
[0, 1].

In the standard binomial option pricing model (BOPM), we assume u and d

to be crisp values so that the stock value at time t = 1 is either

P1= uP0 with probability p OR

P1= dP0 with probability 1-p.

But this assumption of the BOPM neglects the vagueness involved in the
stock price movements in the real world and hence is not expected to
yield a “fair” option price value. To counter this limitation the authors

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have assumed u and d to be fuzzy numbers. For the sake of
computational simplicity they are assumed to be triangular fuzzy
numbers (TFNs).

Fig 1: The two possible jump factors

But How to get the jump factors u & d?

Standard BOPM Analogously for the

fuzzy BOPM
Work done by Cox et al. (1979) Triangular fuzzy numbers u = (u1,
leads to u2, u3) & d=(d1, d2, d3) are given
σ ∆t by
u=e
σ 1 ∆t σ 2 ∆t
d=e
−σ ∆t
=1 , where u1 = e , u2 = e ,
u
σ - volatility of the underlying u3 = e
σ 3 ∆t
(σ 1 < σ 2 < σ 3 )
asset,
∆t - length of the time period. d1 = 1 , d 2 = 1 , d 3 = 1
u3 u2 u3

The three volatility parameters σ1, σ2, σ3 are determined by solving the
following NLPP

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Where
PT defuzzified option price calculated from
the model
PM actual market price of the option
n number of observations from the past
data
r continuously compounded interest rate

The second condition in the NLPP takes care of the no arbitrage

condition (which says that “no transaction or portfolio can make a profit
without risk”). This condition is also intuitively appealing because

r ∆t σ 1 ∆t
• if e > e then

o no investor would wish to invest in the risky assets and

would confine only to the risk free investments and
r ∆t −σ 1 ∆t
• if e < e
o no investor would wish to make any risk free investment

2.2. Risk neutral probability intervals

We introduced p and 1-p as the probabilities of the up and down jump
factors, but how do we get these probabilities. As for the pricing
methodology, a risk neutral (fair) valuation approach is used therefore
these probabilities should be such that they incorporate the “fair” (risk
neutral) pricing strategy.

The aim of this section is to derive these risk neutral probabilities in order
to price a call written on a stock. Let us consider a one period model
where t ∈ {0, 1} is the time
Let pu & p d be the up and down jump probabilities. Then

+ p
pu d

=1
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and from the idea of risk neutral valuation, we require
P0 d × p d + P0 u × pu = P0 (1 + r )

LHS = expected value of P1 (expected value of stock at t =1).

RHS = the value of a risk free investment of amount P0 (invested at time
t=0) at time t=1.

Since u & d are fuzzy numbers, writing them in terms of α – cut we get

(1) α α
∈
Solving these equations for a particular value of d [d ,d 1 3 ] and a
α α
∈ u ,u
1 3
pd pu
particular value of u [ ] we get crisp and values. On
pu
varying
pd d & u values on these intervals we get range of values for and
.
pu pd α
We get maximum possible range of & values at a given – cut
by solving the following two systems of equations

Solving system (2) yields

Solving system (3) yields

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The two solutions thus give the bounds on the probability intervals:

It is easy to check that the following duality relations hold:

pu+p d

=1
pd+p u

=1
Hence for a given α -cut we get intervals for the possible values of pu &
p d . These intervals have a maximum spread at α = 0 and reduce to crisp
values at α = 1. This is justified because it can be easily seen that
derivative w.r.t α is positive for both the left bounds and negative for
both the right bounds of the probabilities.

Also it is easy to verify the following claim

Second derivative Second derivative Second derivative
positive condition negative condition zero condition
pu u3-u2 > d3-d2 u3-u2 < d3-d2 u3-u2 = d3-d2
pu u2-u1 > d2-d1 u2-u1 < d2-d1 u2-u1 = d2-d1
pd u2-u1 < d2-d1 u2-u1 > d2-d1 u2-u1 = d2-d1

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 pd u3-u2 < d3-d2 u3-u2 > d3-d2 u3-u2 = d3-d2

Taking use of the information in the above table we can have different
shapes for curves of pu and p d depending upon the relative positions
of u1, u2, u3 and d1, d2, d3 which are illustrated in tables below

TABLE 2

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 Table3

These tables do not depict the cases in which the second derivative of pu ,
p u , p d , p d are zero when p u & p d are TFNs.

By inspection of the tables 2 & 3, it is clear that the shape of the risk
neutral probabilities depends on the relative positioning of u & d. In
particular if we fix the two peaks, d2 and u2 of the two jump factors, from
table 2 we can see that when the distribution of u is closer to that of d i.e.
u & d are less distinct, then both pu & p d are closer to a crisp number.
Conversely, when u & d are more distinct, pu & p d are more vague

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2.3. Pricing of an option in vague world –
single period model
Having obtained the risk neutral probabilities pu & p d in the previous
section we now use them to price an option on a stock. We only consider
the one period model in this section.

At the time of expiry a call option has a positive value (payoff) if the price
of the underlying stock at that time is greater than the strike price and is
zero otherwise. Now in our fuzzy model at time t=1 the stock price is
either P0d or P0u, which are triangular fuzzy numbers (because u & d
are triangular fuzzy numbers.)

To consider an interesting contract let us assume that the strike price (X)
is between the highest value of stock in the down state and the lowest
value in the up state i.e.

Let us denote
C (u) = the payoff of call in the up state
C (d) = the payoff in the down state.
Then clearly
C (u) = (P0u-X) = (P0u1-X, P0u2-X, P0u3-X)
C (d) = 0
Since u is a TFN ∴C (u) is also a TFN which is given in the α -cut
representation as

Now by the risk neutral valuation strategy we can determine the call price
C0 at t=0 by

Where
Ê refers to the expectation under the risk neutral probabilities
C1 is the call payoff at time t=1

This equation signifies that

• The discounted value of expected call payoff at time t=1 equals

the value of call at time t=0.

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 • condition that the expected returns of the writer and the buyer
should be same at the time of expiry which is precisely the ideology
behind risk neutral valuation.

Since Cd = 0 in our case therefore

The rules of multiplication between fuzzy numbers then lead to

It is easy to prove that as α increases this interval size of call option

price shrinks.
In particular for α =1 the interval reduces to a single crisp value

which is the same result as in standard BOPM (crisp case) with u2 and d2
as up and down jump factors as expected.

Also it is easy to verify the following claims

Second derivative Second Second

positive condition derivative derivative zero
negative condition
condition

C0 (u3-d3)(p0u2-X) > (u3-d3)(p0u2-X) < (u3-d3)(p0u2-X) =

(u2-d2)(p0u1-X) (u2-d2)(p0u1-X) (u2-d2)(p0u1-X)

C0 (u2-d2)(p0u3-X) > (u2-d2)(p0u3-X) < (u2-d2)(p0u3-X) =

(u1-d1)(p0u2-X) (u1-d1)(p0u2-X) (u1-d1)(p0u2-X)

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Taking use of the information in the above table we can have different
shapes of curves of C0 which are illustrated in tables below

TABLE 5

When the second derivative of C 0 & C 0 w.r.t α is zero then C0 is clearly

a TFN.

2.4. Multi period model

Now we can extend the pricing methodology to a general multi period
binomial model. We assume that u & d are same at every stage so that
the binomial tree recombines.

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P1 is either P0 d or P0 u . At t=2 both P0 d & P0 u might move up or
down ∴P2 is either P0 uu or P0 ud or P0 dd . In general, multiplication
of two TFN’s need not be a TFN but for the sake of simplicity we
assume it to be so.
∴We can generalize the stock price at each node of time t by a TFN
given by

Now we describe the pricing of call option for a specific case of 2 period
model which can be extended in a similar fashion to the general n period
model.

Let C (uu), C (ud) and C (dd) denote the payoff of call at t =2 in the
states up-up, up-down, down-down respectively. Let us assume for
simplicity that the strike price X satisfies
P0d3u3 ≤ X ≤
P0u12

∴C (uu) = P0uu-X = (P0u12 – X, P0u22 – X, P0u32 – X)

C (ud) = 0
C (dd) = 0

As in the standard BOPM, we can price the call by backward induction

using the risk neutral valuation strategy. Now since C(ud) & C(dd) are
zero ∴C(d) = 0 & C(u) can be calculated as

This reduces to

Now C0 can be calculated by

This reduces to

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 As α increases, the above calculated interval for possible C0 values
shrinks, in particular for α =1, the interval collapses to a crisp value
which is the same as the standard 2 period BOPM with u2 and d2 as
crisp up & down jump factors.

3. Defuzzification
In order to be able to put the model developed into practical use, we need
to find a crisp value that takes account of all the information in the
weighted call option price interval. This process is called defuzzification.
Let us define a metric D as a distance between a fuzzy number C and a
crisp number x as follows:

where C and C are the left and right limits of the call price respectively.
In order to find the crisp x that is closest to C we need to solve the
problem

Putting the first order derivative of D (C,x) w.r.t x = 0 we get

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 Once the crisp x is determined we can compute D which after some
algebra reduces to the formula

4. Extension Proposed
4.1. Integration of fuzzy BOPM into fuzzy
logic
IDEA: The present fuzzy BOPM takes into account the vague nature of
the stock price movements while calculating the call option price but it
does not take into consideration the dependence of investor’s
decisions on the current overall state of the economy (whether it
is booming or in depression or neutral).

This incapability of the current model is due to

• the fact that the risk free rate of interest (R) is assumed to be
constant in the model irrespective of the state of the
economy/market, which is not the case in real world.
• Intuitively, using R irrespective of the economy state is actually
“unfair”
o for the writer in a booming economy and
o for the buyer in a depressed economy.
• Therefore, “risk-neutral” valuation is a reasonable assumption
only in a fair (neutral) economy
o Where in, the expected returns from risky investments are
comparable to the returns from risk free investments
which is not the case always.
Thus in general, an investor’s decisions are influenced by the state of the
economy which calls for some modification in the model to overcome this
inconsistency.

The extension of the model which we are going to propose will possibly
overcome this incapability by capturing the different market states

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through the use of fuzzy logic rules and fuzzy pattern recognition. Now we
move further to the details of the proposed extension.

Let us classify, as an example, the overall state of economy into three

classes viz.
• Booming – high expected returns from risky investments
• Neutral – expected returns from risky investments are
comparable to the returns from risk free investments
• Depression – low expected returns form risky investments

Now let us assume that from the expert knowledge of the investors we
have obtained the up and down fuzzy jump factors u & d for each of these
three states i.e. we have three fuzzy numbers for u , uH, uM, uL (H – high,
M- medium, L - low) and similarly three fuzzy numbers dH, dM, dL for d. We
present a possible set of logic rules in the table below

Up jump factor - u down jump factor – d

Booming Economy (E1) u = uH d=dL
Neutral Economy (E2) u = uM d=dM
Depression (E3) u = uL d=dH

Now let us associate with each of these states Ei, a control parameter
value (f) which alters the risk free interest rate R to R* (= R x f ) for use
in the fuzzy BOPM. This modified rate of interest (R*) acts as a proxy
variable which captures the current state of the economy and hence
provides a better (“fair”) valuation of the option price.

Intuitively it is easy to see that in a booming economy, since the

expected returns from buying options is high therefore the premium that
the buyer of the option should pay should be greater than that calculated
from the fuzzy BOPM using original risk free interest rate (R). This can be
brought into effect by keeping value of f to be greater than one in the
booming economy state, similar observations can be made for the other
states, which are summarized in the table below

Economy Control
State Parameter (f)
Booming f>1
Neutral f ≈ 1
Depression f<1

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These f values may be decided from the expert knowledge of the
investors, after carrying out extensive research on the historical data.

4.2. Justification for values of Control

Parameter f
As an example consider the expression for C0 interval in the one period
fuzzy BOPM

This can also be considered as

C0 =
 θ θ′ 
λ(1 − 1 + r ), λ′(1 − 1 + r )
where λ , λ ′ , θ , θ ′ are some constants for a given value of α and R =
1+r.

∴Clearly to increase C0 in the booming economy by using R* instead of

R we need to have R* > R which in turn implies f >1. Similar observations
can be made for the other economy states.

But the question which arises now is how you would identify the state of
economy at any particular point of time. This can be achieved through the
concept of fuzzy pattern recognition which in turn uses similarity
measures.

4.3. Pattern Recognition & Similarity

Measures

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 Let at any point in time the jump factors as interpreted by an investor
be u & d (TFNs). Now we wish to know the state of the economy to
which these jump factors resemble the most. For this we need the
concept of similarity measures.

Let B = (u,d) be the new fuzzy input (consisting of two fuzzy numbers:
u and d)
E1, E2, E3 be the three fuzzy classes each having two features Ei1 & Ei2,
where
Ei1 refers to up jump factor in Ei.
Ei2 refers to down jump factor in Ei.

Define the similarity measure between B & Ei as

[B,Ei] = (u,Ei1) + (d,Ei2) , where
1
(u,Ei1) =
2
(u • Ei1 + u ⊕ Ei1 )

u • Ei1 = max min {

x µ u
( x ), µ
Ei1
( x ) } = inner fuzzy product
between u & Ei1
u ⊕ Ei1 = min
x
max { µ u
( x ), µ
Ei 1
( x ) } = outer fuzzy product
between u & Ei1

Let max [B, Ei] = [B, Er] 1 ≤i ≤3

then we say that the current market state resembles Er state the most

Now once we know the current market state by the above pattern
recognition procedure, we take the corresponding control parameter value ‘f’
and use the modified risk free rate of interest R* in the fuzzy BOPM to
calculate the option price which is expected to capture a broader knowledge
of the market as compared to the earlier fuzzy BOPM.

5. Conclusion
This paper tells about the basic aim and strategy involved in developing
any Option Pricing model and provides an overview of the Risk Neutral
valuation strategy for pricing options in a vague market published by
Silvia Muzzioli and Costanza Torricelli in 2004.

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But this existing model doesn’t take into account the role of overall
market sentiments in an investor’s decisions at any point of time. This
incapability is partly due to the use of ‘risk free’ rate of interest directly
into the model, whatever may be the state of the market. This
assumption is a valid one only when the expected returns from risky
investments are comparable to those from risk free investments which
is not the case in skewed economy states like when the economy is
booming or in depression.

Thus this paper review tries to overcome this incapability by integrating

the existing model with fuzzy logic and fuzzy pattern recognition to
identify the state of economy at any point in time and consequently use
a modified risk free rate of interest (R* = Rxf) while calculating the
premium value. This approach is intuitively more appealing and is thus
expected to give better accuracy than the existing model.

A further possible extension could be to use these steps on past data

and validating these results

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