Binomial Model

Modified from the material

taught at the Nottingham University.

1
Contents
1 No-arbitrage 2
1.1 Financial Market Terminology . . . . . . . . . . . . . . . . . . . . . 3
1.2 Equivalent probability measures . . . . . . . . . . . . . . . . . . . . 5
1.3 No-arbitrage (fair market) . . . . . . . . . . . . . . . . . . . . . . . 7

2 Binomial model 10
2.1 Arbitrage-free binomial model . . . . . . . . . . . . . . . . . . . . . 11
2.2 Binomial Model and Option Game . . . . . . . . . . . . . . . . . . 13
2.3 Binomial model representations . . . . . . . . . . . . . . . . . . . . 17

3 Option pricing 19
3.1 One–step arbitrage-free Binomial Model and Option Game . . . . . 20
3.2 Option pricing for Binomial model . . . . . . . . . . . . . . . . . . 26
3.3 Option pricing via hedging: Theory
(for the arbitrage–free binomial model) . . . . . . . . . . . . . . . . 27

1
1 No-arbitrage

Contents

1.1 Financial Market terminology

1.2 Equivalent martingale probability

1.3 No-arbitrage (fair market)

2
1.1 Financial Market Terminology

Market = Discrete time Market with one risky asset (share) and one non-risky
asset (bond).

n = 0,1,2,3,. . . = discrete time.

T = expiry date/time.

Sn = denote the share price at time t.

ρ= fixed interest rate.

(1 + ρ)n = the value of £1 at time n in discrete time.

(1 + ρ)−n = discrete time discount factor, i.e. value of £1 at time −n .

(1 + ρ)−n Sn = discounted share price at time n (discrete time).

C = f (ST )= option claim, payoff at time T (financial derivative of the share price).

(n) (n) (n)

(x0 , x1 ) = the portfolio held by the agent at time t, where (x0 = number of
(n)
bonds held at time n and x1 = number of shares held at time t.

(n) (n)
Wn = x0 (1 + ρ)n + x1 Sn =wealth or capital at time n.

(n) (n)
hedging=to find portfolio strategy (x0 , x1 , n = 0, 1, 2, . . . which gives the payoff
(n) (n)
C = f (ST ) at the maturity time and then the portfolio (x0 , x1 ) is called the
(0) (0)
hedging portfolio and (x0 , x1 ) = (x0 , x1 ) is called the initial hedging portfolio.

x+ = max(0, x) =useful notation.

(ST − K)+ = European call (buy) option, where K is called strike price, that is
the gain is when ST is high or the game is on increasing the share prices.

(K − ST )+ = European put (sell) option that is the gain is when ST is low or the

3
game is on decreasing the share prices.

Q= risk neutral measure, roughly such a measure that share prices yield the same
gain as bonds in average.

arbitrage free market = roughly when the measure Q is risk neutral, that is the
risk must be involved..

OP= OP(f (ST )|t)= arbitrage free time t option price of option claim f (ST ) (ex-
pired at time T ).

4
1.2 Equivalent probability measures
(some proofs and more examples will be added later on).

Terminology/Defn.

Defn
The probability measures P and Q are said to be equivalent (written as P ∼ Q)
if for any set A,

P (A) = 0 iff Q(A) = 0

or in equivalent form

P (A) > 0 iff Q(A) > 0.

Strictly speaking, A must be measurable.

Useful trick. We mostly apply it for discrete measures. Then,
(will be proved)!
the other equivalent form is as follows. For any point x,

P ({x}) > 0 iff Q({x}) > 0.

Example
Let P ({i}) = 1/4, i = 1, 2, 3, 4.
(i) Assume that Q({i}) = 1/8, i = 1, 2, and Q({i}) = 3/8, i = 3, 4.
Then P ∼ Q (equivalent) because both are given on set {1, 2, 3, 4} and

P ({i}) > 0 and Q({i}) > 0 , i = 1, 2, 3, 4.

(ii) Assume that Q({i}) = 1/2, i = 1, 2.

Then P 6∼ Q (not equivalent) because

P ({3}) > 0 and Q({3}) = 0 .

Defn
Given 0 < α (= 1 + ρ the non-risky return), we say that Q is the equivalent
martingale measure to variable Y with probability P = P (Y ∈ A) if

P ∼Q, and EQ [Y ] = α

where we used
Notation
EQ (Y ) is an expectation with respect to the measure Q(Y ∈ A).

5
Example
Assume P (Y = yi ) = pi , i = 1, 2 where p1 , p2 > 0 (risky investment) and y1 < y2
(just a convenient assumption). Then, the Q is equivalent probability measure iff

Q(Y = yi ) = qi > 0.

The Q is equivalent martingale probability measure iff

Q(Y = yi ) = qi > 0 and α = EQ [Y ].

Since

EQ [Y ] = discrete
= y1 Q(Y = y1 ) + y2 Q(Y = y2 )
= y1 q1 + y2 q2
and since Q is probability measure
1 = q1 + q2

which yields
α − y1 y2 − α
q2 = , q1 =
y2 − y1 y2 − y1
and since qi > 0, this requires the necessary and sufficient condition on y1 , y2 , α
(BUT not on P )

y1 < α < y2

6
1.3 No-arbitrage (fair market)
(some proofs and more examples will be added later on)

Example (so-called one period/one step Binomial model).

Consider the market which consists of two assets, labelled 0 and 1: 0=the non-
risky and 1=risky. Let
α = 1 + ρ = 2 be a non-risky return or a return on 1u (one unit of capital) of the
non risky asset;
Y be a risky return on 1u of the risky asset.
In addition assume that

P (Y = 4) = p, P (Y = 3) = 1 − p.

Consider a portfolio x = (x0 , x1 ) of investing x0 in asset 0 (non-risky) and x1 in

asset 1 (risky) with initial capital being w0 = 0, that is

x0 + x1 = 0 .

Take (our choice!)

x0 = −M, x1 = M .

Then, the capital W at time 1 (return on our portfolio) will be

W = x0 × (asset 0/non-risky return ) + x1 × (asset 1/risky return )

= x0 × α + x1 × Y
= M (−α + Y )
= M (−2 + Y )
≥ M (−2 + 3)
(since Y ≥ 3)
= M

SO, we have constructed a portfolio which allows to win (and as much as we want
-nice!) without any risk (or with probability 1).
Such an opportunity is called an arbitrage and no-arbitrage means that it is
NOT possible to construct an investing policy which wins with probability 1 or
without any risk, or simply

fair market=it is NOT possible to win without any risk involved - (”banking as-
sumption”=not nice).

Fact (will be justified later on)

Consider a market consisting of k risky assets, labelled 1, . . . , k and one non-risky

7
asset, labelled 0. Let
α = 1 + ρ = 2 (as before) be a non-risky return or a return on 1u (one unit of
capital) of the non risky asset;
Yi (as before) be a return on 1u of risky asset i, i = 1, . . . , k.
Then, there is no-arbitrage if there exists an equivalent measure Q such as

EQ [Yi ] = α , i = 1, . . . , k.

In words

any Q-average risky return=non-risky

In particular, (will be proved) then

Q-average(return on a portfolio) = as all would be invested in the non-risky asset

Example (so-called one period arbitrage-free Binomial model).

Consider the market which consists of two assets, labelled 0 and 1: 0=the non-
risky and 1=risky. Let
α = 1 + ρ be a non-risky return or a return on 1u (one unit of capital) of the non
risky asset;
Y be a risky return on 1u of the risky asset such that

P (Y = yi ) = pi , i = 1, 2,
where p1 , p2 > 0 (risky investment) and y1 < y2

Then the no arbitrage assumption means that there exists an equivalent prob-
ability measure Q ∼ P such that EQ [Y ] = α and as it was found in the section
Equivalent probability measures
α − y1 y2 − α
q2 = , q1 =
y2 − y1 y2 − y1
that is no-arbitrage condition is

y1 < α < y2

Let (x0 , x1 ) be an investing portfolio, with x0 being invested in the non-risky asset
and x1 being invested in the risky asset.
The initial capital is now

w0 = x0 + x1

and its return, W =capital at time 1, is

W = x0 × (asset 0/non-risky return ) + x1 × (asset 1/risky return )

= x0 × α + x1 × Y = x0 α + x1 Y

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so

EQ [W ] = (Q-average return on the portfolio)

= EQ [x0 α + x1 Y ]
(linearity of expectation)
= EQ [x0 α] + EQ [x1 Y ]
(since x0 , x1 , α are constants)
= x0 α + x0 EQ [Y ]
(since EQ [Y ] = α no-arbitrage assumption)
= x0 α + x1 α = α(x0 + x1 )
(since w0 = x0 + x1 initial capital)
= αw0
= as all would be invested in the non-risky asset

9
2 Binomial model

Contents

2.1 Arbitrage-free binomial model

2.2 Binomial model and Option game

2.3 Binomial model representations

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2.1 Arbitrage-free binomial model

We firstly, introduce the generalised binomial model and then its particular
case binomial model.

Generalised Binomial Model

The share prices S0 , S1 , . . . are given by

S1 = S0 Y1 ,
S2 = S1 Y2 = S0 Y1 Y2 ,
S3 = S2 Y3 = S0 Y1 Y2 Y3 and in general
Sk = Sk−1 Yk = S0 Y1 . . . Yk ,

where Yi are independent with

P (Yi = ui ) = pi , P (Yi = di ) = 1 − pi , low value = di < ui = high value

In words = returns are independent with two values.

Binomial Model
Now, in addition Y, Yi are iid and so there distribution is given by

P (Y = u) = p , P (Y = d) = 1 − p , low value = d < u = high value

In words = returns are iid with two values.

Arbitrage-free binomial model

It is the binomial model with an equivalent martingale probability measure, i.e.

Q(Y = u) = qu , Q(Y = d) = qd ,

where qu and qd are defined from

α−d u−α
EQ [Y ] = α = 1 + ρ =⇒ qu = , qd =
u−d u−d
where ρ=interest rate.

11
one-period arbitrage-free binomial model
We only have share prices S0 (at time 0) and S1 = S0 Y (at time 1).
Alternatively, it is presented via the binomial tree as follows

S1 = S0 u
qu
%
S0
&qd
S1 = S0 d

two-period arbitrage-free binomial model

Now, we consider share prices S0 (at time 0), S1 = S0 Y (at time 1) and S2 (at
time 2).
The binomial tree representation is now

S2 = S0 u2
%qu
S1 = S0 u
qu
% &qd
S0 S2 = S0 ud
&qd %qu
S1 = S0 d
&qd
S2 = S0 d2

Notice!!! The original probabilities pi for generalised binomial model and p for
binomial model are IRRELEVANT to the arbitrage-free model as long as 0 <
pi < 1, 0 < p < 1 and the no-arbitrage assumption holds.

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2.2 Binomial Model and Option Game

Option game or Financial option game is to set up the price for the claim
to be paid or claimed in the future. The price is defined by the arbitrage-free
assumption that all risky return are in Q-average are equal to non-risky.
Let Xi be a capital at time i. Then, since 1u of non-risky investment in one step
gives α,

Xi = αXi−1 = α2 Xi−2 = . . . = αi X0

(where α = 1 + ρ and ρ is the interest rate.)

Hence, the non-risky return in i periods/steps of non-risky investments is αi .
Now, let C be a claim paid at time T . Suppose it corresponds to investment/payment
C0 at time 0.
Then its return C under the arbitrage free assumption has same average as all
would be invested in the non-risky market, i.e.

EQ [C] = αT C0 = (1 + ρ)T

hence the arbitrage free time 0 price of option C to be claimed at time

T is

C0 = (1 + ρ)−T EQ [C]

European call (buy) option

with expiry time T and strike price K is an option/right (not an obligation) to
BUY one share at time T (expiry time) at an agreed price K (strike price). It
gives a gain ST − K if ST > K and 0 otherwise, and so the claim is this case is
C = (ST − K)+ where x+ = max(x, 0).

European put (sell) option

with expiry time T and strike price K is an option/right (not an obligation) to
SELL one share at time T (expiry time) at an agreed price K (strike price). It
gives a gain K − ST if K > ST and 0 otherwise, and so the claim is this case is
C = (K − ST )+ where x+ = max(x, 0).

Hedging, matching or replicating the option game

At each time step i = 0, 1, . . . , T − 1 we construct the usual share-bonds portfolio
(xi0 , xi1 ) such that return at time T will be equal to the claim C and the original
capital is equal to C0 (the price of the claim).
It is possible to do it dynamically going backwards started from period T − 1, T .

13
Alternative way is to hedge conditional share prices.
More exactly, the arbitrage free time k conditional prices of option C to
be claimed at time T are then defined by

Ck (f ) = (1 + ρ)k−T E[C|Sk = f ]

where we need to check all the possible outcomes of Sk .

In particular, to find the initial (or original or time 0) portfolio (x0 , x1 ) =
(x00 , x01 ), we need the arbitrage free time 1 conditional prices of option C
to be claimed at time T defined by

v(u) = (1 + ρ)1−T E[C|S1 = S0 u] and v(d) = (1 + ρ)1−T E[C|S1 = S0 d] .

which is then can be hedged by the usual way

x0 α + x1 S1 = return = v(S1 )
x0 α + x1 S0 u = v(u) = v(S1 )|S1 = S0 u
and
x0 α + x1 S0 d = v(d) = v(S1 )|S1 = S0 d

An Example. Consider a two-period binomial model represented by the following

Binomial tree
60
%
30
% &
15 24
& %
12
&
48/5

Let the interest rate be ρ = 1/4.

The equivalent martingale probabilities are (u = 30/15 = 2, d = 12/15 = 4/5,
α = 1 + ρ = 5/4)

α−d 5/4 − 4/5

qu = = = 3/8 =⇒ qd = 5/8 .
u−d 2 − 4/5

Now, let us find the European call (buy) option with expiry time 2 and strike
price 20, i.e. the claim is C = (S2 − 20)+ .
Consider the (updated) binomial tree

14
 S2 = S0 u2 = 60
%qu =3/8
S1 = S0 u = 30
%qu =3/8 &qd =5/8
S0 = 15 S2 = S0 ud = 24
qu =3/8
&qd =5/8 %
S1 = S0 d = 12
&qd =5/8
S2 = S0 d2 = 48/5
Then,

 S0 u2 = 60 with qu2 = (3/8)2
S2 = S0 ud = 24 with 2qu qd = 2(3/8)(5/8)
S0 d2 = 48/5 with qd2 = (5/8)2


Hence

 (S0 u2 − 20)+ = 40 with qu2 = (3/8)2
C = (S2 − 20)+ = (S0 ud − 20)+ = 4 with 2qu qd = 2(3/8)(5/8)
(S0 d2 − 20)+ = 0 with qd2 = (5/8)2


And, so the arbitrage free time 0 price of option C to be claimed at time 2 or the
European call option price with expiry time 2 and strike price 20, is
ans = (1 + ρ)−2 EQ [(S2 − 20)+ ]
= (1 + ρ)−2 [(S0 u2 − 20)+ qu2 + (S0 ud − 20)+ 2qu qd + (S0 d2 − 20)+ qd2 ]
= (4/5)2 [40 × (3/8)2 + 4 × 2(3/8)(5/8) + 0 × (5/8)2 ] (= 24/5)

To hedge it, we now find arbitrage free time 1 conditional prices of option
C to be claimed at time 2 defined by
v(u) = (1 + ρ)−1 E[C|S1 = S0 u] and v(d) = (1 + ρ)−1 E[C|S1 = S0 d] .
To find, v(u) we will use the part of the binomial tree, started with S1 = S0 u
S2 = S0 u2 = 60
%qu =3/8
S1 = S0 u = 30
&qd =5/8
S2 = S0 du = 24
which then gives
v(u) = (1 + ρ)−1 E[(S2 − 20)+ |S1 = S0 u]
= (1 + ρ)−1 [(S0 u2 − 20)+ qu + (S0 ud − 20)+ qd ]
= (1 + 1/4)−1 [(60 − 20)+ × (3/8) + (24 − 20)+ (5/8)]
= (4/5)[40 × (3/8) + 4 × (5/8)]
= 14

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Similarly, for v(d) we use of the binomial tree, started with S1 = S0 d

S2 = S0 ud = 24
qu =3/8
%
S1 = S0 u = 12
&qd =5/8
S2 = S0 d2 = 48/5

which then gives

v(d) = (1 + ρ)−1 E[(S2 − 20)+ |S1 = S0 d]

= (1 + ρ)−1 [(S0 ud − 20)+ qu + (S0 d2 − 20)+ qd ]
= (1 + 1/4)−1 [(24 − 20)+ × (3/8) + (48/5 − 20)+ (5/8)]
= (4/5)[4 × (3/8) + 0 × (5/8)]
= 6/5

To hedge we find portfolio x0 , x1 which gives return=arbitrage free time 1

conditional prices of option C to be claimed at time 2 more exactly,

x0 α + x1 S0 u = v(u)
and
x0 α + x1 S0 d = v(d)

that is
v(u) − v(d) 14 − 6/5
x1 = = = 32/45 = invested in shares ,
S0 (u − d) 15(2 − 4/5)
uv(d) − dv(u) 2 × 6/5 − (4/5) × 14
x0 = = = −88/15 = invested in bonds ,
α(u − d) 5/4 × (2 − 4/5)

16
2.3 Binomial model representations

Product representation. Arbitrage–free binomial model is defined by

Sk = Sk−1 Yk
where Y, Yk are iid with
Q(Y = u) = qu , Q(Y = d) = qd , qd + qu = 1 , d < u
Iterating (or by induction)
Sk = Sk−1 Yk = [Sk−2 Yk−1 ]Yk = Sk−2 [Yk−1 Yk ] = . . .
Sk = S0 [Y1 . . . Yk ] (rep 1)
Geometric random walk representation. Now, let us apply the ln–transform
or log–transform.
x = exp(ln x)
Then, we get another representation from rep 1
Sk = S0 [Y1 . . . Yk ] = S0 exp(ln[Y1 ]) . . . exp(ln[Yk ])
(use exp(a) exp(b) = exp(a + b)
Sk = S0 exp(ln[Y1 ] + . . . + ln[Yk ]) (rep 2)
or
Sk = S0 exp(Rk ) , where Rk = ln[Y1 ] + . . . + ln[Yk ]
i.e. Rk is a random walk.
Binomial representation or Geometric Binomial representation. Let
εj = (ln[Yj ] − ln[d])/(ln[u] − ln[d])
Then, ε, εj are iid with
[εj |Yj = d] = 0 , [εj |Yj = u] = 1
and hence
P (εj = 1) = P (Yj = u) = qu , P (εj = 0) = P (Yj = d) = qd .
Observe that
εj = ln[Yj ] − ln[d]/(ln[u] − ln[d]) =⇒ ln[Yj ] = ln[d] + εj ln[u/d]
and hence
k
X k
X
ln[Y1 ] + . . . + ln[Yk ] = ln[Yj ] = (ln[d] + εj ln[u/d])
j=1 j=1
k
X
= k ln[d] + ln[u/d] εj
j=1

17
and
k
X
εj = sum of iid Bernoulli trials with prob(success) = qu
j=1
= Bin(k, qu )

Hence

ln[Y1 ] + . . . + ln[Yk ] = k ln[d] + ln[u/d]Bin(k, qu )

=⇒
Sk = S0 exp(ln[Y1 ] + . . . + ln[Yk ])
= S0 exp(k ln[d] + ln[u/d]Bin(k, qu ))
= S0 uBin(k,qu ) dk−Bin(k,qu ) (rep 3)

18
3 Option pricing

Contents

3.1 Option pricing via hedging: One-step binomial model

3.2 Option pricing for Binomial model

3.3 Option pricing for Brownian motion model

3.4 Option pricing via hedging: Theory

19
3.1 One–step arbitrage-free Binomial Model and Option
Game
Extended Summary and The main lemma

One–step Binomial Model. The model consists of TWO assets:

a risky asset=share with share prices

S0 , S1 = S0 Y P (Y = u) = p P (Y = d) = 1 − p ,
where u = high value and d = low value and so d < u
and where 0 < p < 1 indicates that Y is a risky (not a fixed) return .

and a non-risky asset=bond with return α = 1 + ρ where ρ a fixed interest.

The model is presented via the binomial tree as follows

S1 = S0 u
%
S0
&
S1 = S0 d

Arbitrage in the one–step binomial model

Assume

α=1+ρ≥u>d

Consider a portfolio x = (x0 , x1 ) of investing x0 in asset 0 (non-risky) and x1 in

asset 1 (risky) with initial capital being w0 = 0, that is

x0 + x1 S0 = 0 .

and take

x0 = M S0 , x1 = −M .

Then, the capital W at time 1 (return on our portfolio) will be

W = x0 × α + x1 × S1
= M S0 α − M S0 Y
= M S0 (α − Y )
≥ M S0 (α − u)
≥ 0

and in addition

P (W > 0) = P (M S0 (α − Y ) > 0) = P (Y = d) > 0

20
that is we constructed a portfolio x = (M S0 , −M ) which allows to win without
any risk (or with probability 1) which means the ARBITRAGE in the model.
Let us consider the other case

α=1+ρ≤d<u

Then the arbitrage portfolio is x = (−M S0 , M ).

Exercise 1 Prove it (stated in the Additional part 2 with solutions will be pro-
vided later on).

No-arbitrage condition in the one–step binomial model

Then the no-arbitrage condition is

d<α=1+ρ<u

And under this condition for any portfolio x = (x0 , x1 ) with initial wealth x0 +
x1 s0 = w0 = 0, the return W = x0 α + x1 S1 is risky in the sense that

P (W < 0) > 0.

Exercise 2 Prove it (stated in the Additional part 2 with solutions will be pro-
vided later on).

Arbitrage-free one–step binomial model

It is the binomial model under the no-arbitrage condition, there exists a UNIQUE
equivalent martingale probability measure

Q(Y = u) = qu , Q(Y = d) = qd ,

where qu and qd are defined from

1+ρ−d u − (1 + ρ)
EQ [Y ] = α = 1 + ρ =⇒ qu = , qd =
u−d u−d
where ρ=interest rate.
The measure is defined by u, q and ρ and does NOT depend on the initial proba-
bility P (which is irrelevant for option pricing).
The model is presented via the binomial tree as follows

S1 = S0 u
qu
%
S0
&qd
S1 = S0 d

Fair game

21
Assume that ρ = 0 then the gain in the arbitrage–free one–step binomial model is

return - minus invested = EQ [Y ] − 1 = 1 + ρ − 1 = 0

In another words, it is a fair game in the terminology of stochastic games, i.e.

no-arbitrage = fair (financial) game.

Option game: Terminology

The initial capital = the option price.
The return capital = the option claim C = f (S1 )(= C(Y )).
Portfolio = the vector x = (x0 , x1 ) of investments x0 in bonds and x1 in shares.
Hedging = for a given option claim C find the portfolio which gives the return C.
Hedging portfolio = portfolio (x0 , x1 ) with return C.
Option game = to find the hedging portfolio (x0 , x1 ) with the given return/option
clam C.

Risky return in the arbitrage-free one–step binomial model

The initial capital is

C0 = x0 + x1 S0

and its return, capital at time 1=option claim C, is

C = x0 × α + x1 × S1
= x0 × α + x1 × S0 Y =⇒
EQ [C] = EQ [x0 × α + x1 × S0 Y ]
= x0 × α + x1 × S0 EQ [Y ]
since x0 , S0 , x1 are constants
= x0 × α + x1 × S0 α
since EQ [Y ] = α under the no–arbitrage condition
= α[x0 + x1 S0 ]
= αC0

that is we have proved

EQ [risky return] = non- risky return

Equivalently, for any PORTFOLIO (x0 , x1 ) with initial capital C0 and return C

EQ [C] = αC0 (1)

Hedging in the arbitrage-free one–step binomial model

We need to find the portfolio (x0 , x1 ) which yields the return (hedges/matches)
C, that is

x0 α + x1 S1 = C

22
which is presented via the binomial tree as

C(u)
%
(x0 , x1 ) S0
&
C(d)

where

C(u) = C|Y = u , C(d) = C|Y = d .

This is equivalent to the simple system of two equations

x0 α + x1 S0 u = C(u)
and
x0 α + x1 S0 d = C(d)

with the solution

C(u) − C(d)
x1 = = invested in shares ,
S0 (u − d)
uC(d) − dC(u)
x0 = = invested in bonds .
α(u − d)

Option pricing via hedging in the arbitrage-free one–step binomial model

From the risky return formula (1), we immediately derive that the option price
C0 for the hedging portfolio (x0 , x1 ) with option claim C satisfies

EQ [C] = αC0 = (1 + ρ)C0 =⇒ C0 = (1 + ρ)−1 EQ [C]

stated as
option price = (1 + ρ)−1 EQ [C]

The fact also follows from the following direct (tedious!) calculations

C0 = x0 + x1 S0
uC(d) − dC(u) C(u) − C(d)
= + S0
α(u − d) S0 (u − d)
uC(d) − dC(u) C(u) − C(d)
= +
α(u − d) u−d
1 [uC(d) − dC(u)] + α[C(u) − C(d)] 

=
α u−d
1 α−d u − α
= C(u) + C(d)
α u−d u−d
1
= (C(u)qu + C(d)qd )
α

23
 1
= EQ [C(Y )]
α
1
= EQ [C]
α
1
= EQ [C]
1+ρ

24
Lemma (1step lemma)
The one–step arbitrage–free binomial model is defined by

S0 , S1 = S0 Y Q(Y = u) = qu Q(Y = d) = 1 − p ,

under the no-arbitrage condition d < 1 + ρ < u where

Q(Y = u) = qu , Q(Y = d) = qd ,

where qu and qd are defined from

1+ρ−d u − (1 + ρ)
EQ [Y ] = α = 1 + ρ =⇒ qu = , qd =
u−d u−d
where ρ=interest rate.
Each option claim C = C(Y ) = f (S1 ) has the option price

C0 = (1 + ρ)−1 EQ [C]

and there exists a hedging portfolio (x0 , x1 )

C(u) − C(d)
x1 = = invested in shares ,
S0 (u − d)
uC(d) − dC(u)
x0 = = invested in bonds .
α(u − d)

which has the return = option claim C.

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3.2 Option pricing for Binomial model

Reminder
We say that stock price {Sk ; k = 0, 1, 2 . . .} follows an arbitrage–free binomial
model if

Sk = Sk−1 Yk

where Y, Yi are iid with two values and such that EQ [Y ] = 1 + ρ, ρ- is an interest
rate, that is

1+ρ−d u − (1 + ρ)
Q(Y = u) = qu = , Q(Y = d) = ,
u−d u−d
and where we assume the no-arbitrage condition so d < 1 = ρ < u.
The non–risky return from time 0 to time n is defined by (1 + ρ)n .
As before, we consider homogeneous models where the interest rate does NOT
depend on time and so

(1 + ρ)n = non–risky return from time u to time u + n

If the time n < 0 it is the DISCOUNT factor.

Arbitrage–free time 0 price of the claim C = f (ST ), T > 0, in the Binomial
model is defined by

option price = (1 + ρ)−T EQ [C] = (1 + ρ)−T EQ [f (ST )]

= (1 + ρ)−T EQ [f (S0 Y1 . . . YT )]

where we need to do the calculations under the Q measure, probabilities.

The model admits various representations:

Sk = S0 [Y1 . . . Yk ]
Sk = S0 exp(ln[Y1 ] + . . . + ln[Yk ]) .
Sk = S0 exp(k ln[d] + ln[u/d]Bin(k, qu )) .

NOTICE: The stock price in the argitrage–free generalised binomial model has
the same distribution provided that the interest rate is fixed and independent
returns Yi have the same high and low values u and d for all i.

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3.3 Option pricing via hedging: Theory
(for the arbitrage–free binomial model)

n–step arbitrage–free binomial model. The model consists of TWO assets.

A risky asset=share with share prices defined by

Sn = Sn−1 Yn

where Y, Yi are iid with two values and such that EQ [Y ] = 1 + ρ, ρ- is an interest
rate, that is
1+ρ−d
Q(S1 = uS0 ) = Q(Y = u) = qu = ,
u−d
u − (1 + ρ)
Q(S1 = dS0 ) = Q(Y = d) = qd = ,
u−d
and where we assume the no-arbitrage condition: d < 1 = ρ < u.
And the non–risky asset=bond with return from time 0 to time n defined by
(1 + ρ)n .

Option game: Terminology

The initial capital = the option price = so-called time 0 arbitrage–free option price.

The return capital = the option claim C = f (ST ).

n−1 (k) (k)

n−1 (k)
Portfolio = the sequence of vectors (x(k) )k=0 = (x0 , x1 )k=0 of investments x0
(k) (k) (k)
in bonds and x1 in shares at time k = 0, 1 . . . , n − 1. The investment x0 , x1 is
now random since depends on the current share price Sk .

Hedging = for a given option claim C find the portfolio sequence which gives the
return C.

(k) (k)
Hedging portfolio = portfolio sequence (x(k) )n−1 n−1
k=0 = (x0 , x1 )k=0 with return C.

(0) (0)
Initial hedging portfolio = the time 0 part x = (x0 , x1 ) = xk=0 = (x0 , x1 ) of the
hedging portfolio.

(k) (k)
Option game = to find the hedging portfolio sequence (x(k) )n−1 n−1
k=0 = (x0 , x1 )k=0
with the given
return/option clam C.

We are going to show that:

The hedging portfolio exists.

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The prices at each stage k are given by the arbitrage free time k conditional
prices of option C to be claimed at time T are then defined by

vk (f ) = (1 + ρ)k−n EQ [C|Sk = f ]

where we need to check all the possible outcomes of Sk .

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Proof.
The main idea: Observe that Sk is a Markov chain and so by Markov property

[Sk , Sk+1 , . . . , Sk+n |Sk = s] =d [S0 , S1 , . . . , Sn |S0 = s]

Now, we apply a backward-type induction on n.

The case n = 1 follows from the 1 step lemma.
Now, assume the case n − 1.
n − 1 → n. The trick is to consider the model from time 1 to n (BACKWARD
thinking). Then, by the Markov property and shift this is the same as considering
the model from time 0 to n − 1 but with the initial state being:
either S1 = uS0 or S1 = dS0 .
Case S1 = uS0 . Observe that

[S1 , S2 , . . . , Sn |S1 = uS0 ] =d [S00 , S10 , . . . , Sn−1

0
|S00 = uS0 ]

and by the induction assumption there exists the hedging portfolio (sequence of
0
portfolios!) with the return C = f (Sn−1 ) = f (Sn ) and option price

C00 = (1 + ρ)1−n EQ [f (Sn−1

0
]
0 0
since [Sn−1 |S0 = uS0 ] = [Sn |S1 = uS0 ]
= (1 + ρ)1−n EQ [f (Sn )|S1 = uS0 ]
= (1 + ρ)1−n EQ [C|S1 = uS0 ]
= v(u)

Case S1 = dS0 . Similarly, now,

[S1 , S2 , . . . , Sn |S1 = dS0 ] =d [S000 , S100 , . . . , Sn−1

00
|S000 = dS0 ]

and by the induction assumption there exists the hedging portfolio (again sequence
0
of portfolios) with the return C = f (Sn−1 ) = f (Sn ) and option price

C000 = (1 + ρ)1−n EQ [f (Sn−1

00
]
00
since [Sn−1 |S00 = dS0 ] = [Sn |S1 = dS0 ]
= (1 + ρ)1−n EQ [f (Sn )|S1 = dS0 ]
= (1 + ρ)1−n EQ [C|S1 = dS0 ]
= v(d)

And it remains to identify the initial hedging portfolio (x0 , x1 ) and its initial price
C0 . The returns are v = v(d), v(u) and so

x0 α + x1 S0 u = v(u)
and
x0 α + x1 S0 d = v(d)

29
with the solution (by 1 step Lemma)

v(u) − v(d) uv(d) − dv(u)

x1 = , x0 = .
S0 (u − d) α(u − d)

Now, the initial price again by 1 step Lemma is

C0 = (1 + ρ)−1 EQ [v]
= (1 + ρ)−1 [qu v(u) + qd v(d)]
 
= (1 + ρ)−1 (1 + ρ)1−n EQ [C|S1 = uS0 ]qu + (1 + ρ)1−n EQ [C|S1 = dS0 ]qd
by the above
 
= (1 + ρ)−n EQ [C|S1 = uS0 ]qu + EQ [C|S1 = dS0 ]qd
 
= (1 + ρ)−n EQ [C|S1 = uS0 ]Q(S1 = uS0 ) + EQ [C|S1 = dS0 ]Q(S1 = dS0 )
by the definition of the martingale probabilities
= (1 + ρ)−n EQ [C]

where at the end we have applied the tower lemma, i.e.

E[C] = E(E[C|S1 )]
= EQ [C|S1 = uS0 ]Q(S1 = uS0 ) + EQ [C|S1 = dS0 ]Q(S1 = dS0 )

30