ESTM 60202: Financial Mathematics

Alex Himonas

03–Lecture Notes1
October 7, 2009

1 Introduction to Option Pricing

We begin by defining the needed finance terms.
Stock is a certificate of ownership of a company. A share is a unit of stock. At any given time,
t = 0, the stock value, S0 , is given by
Market value of company
S0 =
Number of shares of company

Example 1. If a company today has 40 million shares and the value of each share is $50, then the
market value of the company is $50 × 40 million or $2 billion.

European call option gives the owner the right but not the obligation to buy a share of stock at
a specified price K, which is exercised only on the future date T stated in the contract. The time
T , at which the option can be exercised, is called the maturity date. The predetermined price K
is called the strike price.

Example 2. Today the value of a share of a given company is S0 = $50. Buying one European
call option with maturity date T = 1 and strike price K = $70 means that a year later you have
the right to buy a share of stock. If S1 > 70 then you would exercise the option. While, if S1 ≤ 70
then you would let the option expire. Your profits would be

+ S1 − 70 if S1 − 70 > 0 ,
[S1 − 70] = (1.1)
0 if S1 − 70 ≤ 0 .
The Question: What is a fair price (not strike price) of a European call option?

1.1 The one-period binomial option pricing model

Imagine the following situation: You live in an (economic) world which consists of stocks (all of the
same kind) and money (dollars) deposited in a bank or borrowed from a bank. The bank charges
you the interest rate r when you borrow money from the bank and pays you the same interest rate
r when you deposit money in the bank.

Question. Think about how the development below changes in the more realistic case in which
the lending rate is above the deposit rate.

Let us assume that at the time t = 0 the value of a share of the stock is S0 (say $50 as in
Example 2). One period later (say 1 year) the stock can take one of the following values: S1 (H) or
S1 (T ) (say S1 (H) = 100 or S1 (T ) = 25) as is indicated in the following diagram:
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Based on joint notes with Tom Cosimano

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 S1(H)
p

S0

1-p
S1(T)

You can imagine that at time t = 1 the price of the stock is determined by a weighted coin toss.
That is, this coin is tossed and if the outcome is H then the price is S1 (H), while if the outcome is
T then the price is S1 (T ). (In probabilistic terms S1 is a random variable.) Let us denote this by

p = P (H) and 1 − p = P (T ).
We can always assume
0 < S1 (T ) < S1 (H).
Otherwise, we just change notation.

Question. Why do we assume that the stock price is always positive?

Since S1 (H) is the ‘up stock value’ and S1 (T ) is the ‘down stock value’ it is helpful to introduce
the terminology

S1 (H) S1 (T )
u= = up factor, and d = = down factor.
S0 S0
Since
0 < S1 (T ) < S1 (H) it follows that 0 < d < u.
The interest rate for this period in the economy is denoted by r (say r = 0.05 or 5%).
Therefore, we have that $1 deposited in the bank at time t = 0 becomes 1 + r at t = 1. In other
words we have the following diagram:

1+r
p

$1

1-p
1+r

We now introduce a fundamental idea in finance. First define the following:

Arbitrage is a trading strategy which:

1. Begins with zero money.

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 2. Has a zero probability of losing money.
3. Has positive probability of making money.
No Arbitrage Axiom (NA). It is impossible to have a trading strategy which can turn nothing
into something without running the risk of a loss. That is, there is no arbitrage.
Lemma 1.1 If there is no arbitrage (NA) then
d < 1 + r < u. (1.2)
Proof. (By contradiction) First we prove that d < 1 + r. If the opposite is true, that is d ≥ 1 + r,
then at t = 0 we could borrow from the bank S0 dollars to buy one share of stock. Then no matter
what is the outcome of the coin toss at time t = 1 our stock will be worth S1 ≥ dS0 , while we will
need (1 + r)S0 to pay off the loan from the bank. Therefore with a certain probability of 1 we will
be making a profit of
S1 − (1 + r)S0 ≥ dS0 − (1 + r)S0
= [d − (1 + r)]S0 (1.3)
≥ 0, since d ≥ 1 + r.
Also, with probability p > 0 we will make a profit equal to
S1 (H) − (1 + r)S0 = uS0 − (1 + r)S0
≥ (u − d)S0 (1.4)
> 0, since u > d.
Thus, we have produced a strategy which begins with zero money, has a zero probability of losing
money, and positive probability of making money. This violates the NA axiom. Therefore, inequality
d ≥ 1 + r is false.
Next we prove that 1 + r < u, again by contradiction. If 1 + r ≥ u, then at t = 0 we could
borrow a share of stock (this is called short selling a stock), sell it for S0 dollars, and invest the
proceeds in a bank paying interest r. At t = 1 this deposit at the bank would grow to (1 + r)S0 .
At this time to replace the stock borrowed at time t = 0, in the worst situation it would cost uS0 .
Therefore, with a certain probability of 1 this strategy produces a gain of
(1 + r)S0 − S1 ≥ (1 + r)S0 − uS0
= [(1 + r) − u]S0 (1.5)
≥ 0, since 1 + r ≥ u.
Also, with probability 1 − p > 0 we will make a profit equal to
(1 + r)S0 − S1 (T ) = (1 + r)S0 − dS0
≥ (u − d)S0 (1.6)
> 0, since u > d.
Thus, again we have produced a strategy which violates the NA axiom. 
Remark. The reason why the NA axiom comes about follows from this proof. If you had the
inequality d ≥ 1 + r, then companies would find it profitable to buy lots of stock at time 0 with
price S0 . As this occurs the price S0 would be bid up. As a result, both u and d would go down.
Thus, the profit motive or the fact that people and corporations are greedy leads to the NA axiom
in finance.

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1.2 Computing the price of a European call option
Here we assume the 1-period binomial model satisfying the NA axiom

0 < d < 1 + r < u. (1.7)

In this case it is natural to require that the strike price K satisfies the condition

S1 (T ) < K < S1 (H). (1.8)

If we denote by V0 the unknown price of the option at time t = 0 and V1 (H) and V1 (T ) the two
possible payoffs for the European call option at time t = 1, then we have the following diagram for
this option.
V1(H) = S1(H) - K
p

V0 ?

1-p
V1(T) = 0

Now we are ready to state our main result which is the Black-Scholes option pricing formulas in
our one period two state world.
Theorem 1.2 [Binomial Black-Scholes formula] The price V0 of a European call option in the
one-period binomial model is given by

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V0 = [p̃ V1 (H) + q̃ V1 (T )] , (1.9)
1+r

where
(1 + r) − d u − (1 + r)
p̃ = , and q̃ = , (1.10)
u−d u−d
and V1 (H) and V1 (T ) are the two possible payoffs.

Remark 1. The probability p does not appear explicitly in the formula.

Exercise 1. Can you think of how p enters into the pricing of the call option?

Remark 2. Note that both p̃ and q̃ are positive and that p̃ + q̃ = 1. They look like probabilities
and are called risk-neutral probabilities.

Exercise 2. Think why p̃ and q̃ are called risk-neutral probabilities. Also, explain why p and
q = 1 − p must satisfy the inequality
1 h i
S0 < p S1 (H) + q S1 (T ) . (1.11)
1+r

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Example 3. If S0 = 50, S1 (H) = 100, S1 (T ) = 25, K = 70 and r = 0.05, then we have

S1 (H) 100 S1 (T ) 25 1
u= = = 2, and d = = = = 0.5.
S0 50 S0 50 2
The possible payoffs are

V1 (H) = S1 (H) − K = 100 − 70 = 30, and V1 (T ) = 0.

Also,
1 + 0.05 − 0.5 0.55 55
p̃ = = = ,
2 − 0.5 1.50 150
and
2 − (1 + 0.05) 0.95 95
q̃ = = = .
2 − 0.5 1.50 150
Therefore, applying formula (1.9) gives
 
1 55 95 11
V0 = · 30 + ·0 = ≈ 10.48 dollars. 
1 + 0.05 150 150 1.05

Next, we provide the terminology needed in the proof of Theorem 1.2.

Portfolio is a combination of assets held and liabilities incurred.
Option Replication: Finding the correct initial wealth X0 , in money, and the number ∆0 of
shares of stock that we need to buy in order to replicate a European call option.
Proof of Theorem 1.2. Let us assume that we begin with a wealth of X0 dollars and that we
buy ∆0 shares of stock. Then at time t = 0 we hold a portfolio with:

1. Cash position deposited in the bank X0 − ∆0 S0 .

2. ∆0 shares of stocks.

The value of this portfolio at time t = 1 is equal to

X1 = ∆0 S1 + (1 + r)(X0 − ∆0 S0 ).

Therefore, we have the diagram of payoffs from the wealth invested in the portfolio.
X1(H)
p

X0 ?

1-p
X1(T)

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 Replicating the option would create the same payoffs as the option. As a result, we want to
choose X0 and ∆0 such that

X1 (H) = V1 (H) and X1 (T ) = V1 (T ).

Using the formula for X1 , these two equations take the form

 ∆0 S1 (H) + (1 + r)(X0 − ∆0 S0 ) = V1 (H) ,

∆0 S1 (T ) + (1 + r)(X0 − ∆0 S0 ) = V1 (T ).


After separating the X0 from the ∆0 terms, we have

  1  1
 X0 + 1+r S1 (H) − S0 ∆0 = V (H) ,
1+r 1
(1.12)
1 1
 
X0 + S (T ) − S0 ∆0 = V (T ).

1+r 1 1+r 1

Subtracting the second from the first equation gives

1 1
[S1 (H) − S1 (T )] ∆0 = [V1 (H) − V1 (T )] .
1+r 1+r
Solving for ∆0 we obtain the so called delta-hedging formula:

V1 (H) − V1 (T )
∆0 = . (1.13)
S1 (H) − S1 (T )

Next, substituting in the first equation of system (1.12) formula (1.13) gives
 
1 V1 (H) − V1 (T ) 1
X0 + S1 (H) − S0 · = V1 (H).
1+r S1 (H) − S1 (T ) 1+r

Then, letting S1 (H) = uS0 and S1 (T ) = dS0 we obtain

 
1 V1 (H) − V1 (T ) 1
X0 + u − 1 S0 · = V1 (H).
1+r S0 (u − d) 1+r

Eliminating S0 and solving for X0 gives

 
1 1 V1 (H) − V1 (T )
X0 = V1 (H) + 1 − u ·
1+r 1+r u−d
 
1 V1 (H) − V1 (T )
= V1 (H) + (1 + r − u) ·
1+r u−d
    
1 1+r−u 1+r−u
= 1+ V1 (H) − V1 (T ) ,
1+r u−d u−d
or  
1 (1 + r) − d u − (1 + r)
X0 = · V1 (H) + · V1 (T ) . (1.14)
1+r u−d u−d
This value of X0 must be equal to V0 , the desired price of the European option. This completes the
proof of the theorem. 

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Example 3. (Continued) In the case of Example 3, using delta-hedging formula ( 1.13), we find
that
30 − 0 2
∆0 = = .
100 − 25 5
That is, to replicate this option we must buy 2/5 shares of stock. This will cost ∆0 S0 = (2/5) · 50 =
20 dollars. Therefore, our cash position is X0 − ∆0 S0 = (11/1.05) − 20 ≈ −9.52, which means we
need to borrow 20 − (11/1.05) dollars from the bank at the interest rate of r = 0.05.

Exercise 3. Find the price of a European option for a stoch whose value today is $40 a share, its
up value is $60 and its down value is $30, its strike price a year from now is $50, the annual interest
rate is 4% and the probability of the good state is 0.6.
Exercise 4. For a stock in a binomial world assume that S0 = 100, S1 (H) = 140, S1 (T ) = 75,
and r = 0.08. What is the price of a “novel” call option for this stock which at t = 1 has payoffs
V1 (H) = 25 and V1 (T ) = 5.
Exercise 5. Derive a formula for the price of a European put option in the case of the one-period
binomial option pricing model.
Exercise 6. Find the price of a European put option for a stock whose value today is $100 a share,
its up value is $150 and its down value is $75, its strike price a year from now is $125, and the
annual interest rate is 5%.

Unresolved Issues
1. In the Theorem the formula for the option price is independent of the probabilities of the ups and
down movements in stock. This result is puzzling since the purpose of the option is to insure the
purchaser against events they do not want to occur. We will see that the probabilities are related
to the variables u = S1S(H)
0
and d = S1S(T
0
)
. The reason for this is that the stock price today S0 is
dependent on the probability of the good and the bad state. For example, if there is a 100% chance
of the high price next period, then the stock price today would be much higher relative to a 100%
chance of the low price next period. Consequently, taking the stock price today as given implicitly
assumes a given probability of an up and down move. In future classes we will show this explicitly.

2. We have not discussed why someone would want to buy or sell a European call option. A buyer
would want to use the call option to insure against a particular change in prices. For example
suppose you run an Airline in which your cost of operation is dependent on oil prices since jet fuel
prices go up whenever the price of oil goes up. Now suppose the call option the airline bought pays
off when the price of oil goes up. For example it could be a call option on BP stock. Now when
the price of oil goes up, your airline would face higher jet fuel cost. On the other hand they make a
bigger payoff on the option written on BP. Thus, the call option reduces fluctuations in the profits
of the airline company when the price of oil goes up. If the airlines do not like uncertainty, then
they are made better off.
This opens the question as to why someone would sell a call option. It turns out that an oil
drilling company may also want to avoid fluctuations in oil prices since they make their money
mainly from producing oil and they wish to avoid uncertainty. As a result, the oil drilling company
(say BP) would sell a call option on its oil. When the price of oil goes down below a certain level,
the call option on BP stock is not exercised and so BP make a profit V0 per share. As a result, the

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decreased value of oil for the oil drilling company is canceled (partially?) by the profit of the call
options sold. Thus, the call option also insures the oil drilling company against fluctuations in the
price of oil. Why this works will be discussed in more detail as we go through the semester.

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