Binomial Model: Single Step 1

Assumptions
Pricing the Replicating Portfolio
General Formulas
Exercises

Assumptions 2

What is the price of an option?

We will start to build a model to answer this.
Binomial Model (Fantasy) Assumptions:
• Market includes risk free asset (e.g. zero-coupon bond) and risky asset (we’ll
assume stock). No arbitrage exists.
• Everything occurs in discrete time units
• Only 2 possible cases per time period:
• Stock goes up by predetermined amount
• Stock goes down by predetermined amount
• No costs for trades
• Investor can short sell assets they do not own, resulting in a negative amount of
that asset. (Long = own positive number of asset, short = owe / have negative
number of asset)
Binomial Pricing Example 3

Suppose the risk free rate is 4%. A stock has a current price of $30. In 1 year the
stock price will either increase to 40 or decrease to 25. What is the fair price of a
European put option with K = 35 expiring in 1 year?

Plan:
1. Create the binomial stock tree
2. Calculate the put payoffs at expiration
3. Find replicating portfolio whose value we can compute

Drawing the Binomial Tree 4

Payoff for put with K = 35:

S1 = 40
Don’t exercise put, get 0

S0 = 30
S1 = 25
Put worth 35 − 25 = 10

We want to replicate these payoffs.

• At time t = 0, put $a in a risk free asset and spend $30b on b shares of stock
• At time t = 1, get 0 if the stock goes up and 10 if it goes down.
Have two unknowns (a and b) and will get 2 equations, one per outcome
Replicating Portfolio 5

At t = 0, have $a in a risk free asset and b shares of stock. r = 0.04. If price goes up
(or down), at t = 1 have (respectively):

ae rt + 40b = 0 if stock goes up

ae rt + 25b = 10 if stock goes down
15b = −10 by subtracting 2nd equation from first
b = −2/3
a = [0 − 40(−2/3)] e −rt = 40 · (2/3)e −0.04 = 25.62

Investing 25.62 in a risk free asset and shorting 2/3 of a share of stock at time 0
replicates the put. This is called a replicating portfolio or hedge portfolio
No arbitrage ⇒ both approaches must be worth same amount.

Put value at time 0 is 25.62 − (2/3) · 30 = 5.62

Setup 6

Notations / assumptions:
• At time 0, stock price is S0
• At time t = 1, either stock price goes up to uS0 or down to dS0
• Invest $a in risk free asset with rate r at time 0
• No arbitrage implies dS0 < S0 e r (if not, borrowing money to buy stock always
wins)
• No arbitrage also implies S0 e r < uS0 (if not, short as much stock as possible to
put in bank always wins)
• Likewise need dS0 < K < uS0 for option contract to make sense
• Buy b shares of stock at time 0
• Option pays Cu if stock goes up, Cd if stock goes down
This framework lets us consider either puts or calls
Creating Replicating Portfolio 7

At time t = 0, have $a in risk free at rate r , and b shares of stock.

Solving for t = 1 gives

ae r ·1 + b · uS0 = Cu
ae r ·1 + b · dS0 = Cd
Cu − Cd
b=
(u − d)S0
a = (Cu − b · uS0 )e −r
 
u d
= e −r Cd − Cu
u−d u−d

Skipping some algebra as memorizing a not needed

Option Value 8

The replicating portfolio value at t = 0 gives us the option value, or

er
 
−r u d Cu − Cd
v (0) = a + bS0 = e Cd − Cu + · S0 · r
u−d u−d (u − d)S0 e
  r
u − er
   
e −d
= e −r Cu + Cd
u−d u−d
h i
v (0) = e −r Cu (1 − q) + Cd · q

u − er
for q =
u−d
We will discuss how to remember this next lesson
Initial Example Revisited 9

In our first example:

S0 = 30
u · S0 = 40 ⇒ u = 4/3
d · S0 = 25 ⇒ d = 5/6
Cu = 0 Cd = 10
Cu − Cd 0 − 10 −2
b= = =
(u − d)S0 (4/3 − 5/6) · 30 3
 
4/3 5/6
a = e −0.04 · 10 − ·0
4/3 − 5/6 4/3 − 5/6
 
(4/3)
= e −0.04 · 10 = 25.62
1/2
a + bS0 = 25.62 − (2/3) · (30) = 5.62
4/3 − e 0.04
 
−0.04
or: v (0) = e 0(1 − q) + 10 · = 5.62
4/3 − 5/6

Binomial Pricing: Calls vs. Puts 10

Some comments about our formula:

For calls:
• Cu > Cd
• 0≤b≤1
• a≤0
• The replicating portfolio buys stock and borrows money

For puts:
• −1 ≤ b ≤ 0
• a≥0
• The replicating portfolio shorts stock and lends money
Formulas assume 1 step takes 1 unit of time. If discount rate is an annual rate, but
step length T isn’t a year, use rT in place of r throughout.
Exercise 1 11

The price for XYZ is modeled using a 1 step binomial tree. The current price is 60,
with u = 4/3 and d = 3/4. For a call option with a strike price of 50, find Cu and Cd .

Exercise 1 11

The price for XYZ is modeled using a 1 step binomial tree. The current price is 60,
with u = 4/3 and d = 3/4. For a call option with a strike price of 50, find Cu and Cd .

S0 = 60
4
u · S0 = · 60 = 80
3
3
d · S0 = · 60 = 45
4
(
80 − 50 = 30 when we go up
(ST − K )+ =
(45 − 50)+ = 0 when we go down
Cu = 30
Cd = 0
Exercise 2 12

Consider an at-the-money European call option expiring in 6 months. The underlying

stock follows a binomial process. The stock price today is $100, and in six months it
will be either $120 or $90. The continuously compounded annual risk-free rate is 3%.
Calculate the call price.

Exercise 2 12

Consider an at-the-money European call option expiring in 6 months. The underlying

stock follows a binomial process. The stock price today is $100, and in six months it
will be either $120 or $90. The continuously compounded annual risk-free rate is 3%.
Calculate the call price.

Our formulas assume expiry time 1. Here, 1 time period is 6 months, or only 1/2 a
year. So instead of using 3% to discount, we want to use rT = 3% · 0.5 = 1.5%

K = 100
Cu = 120 − 100 = 20
Cd = (90 − 100)+ = 0
u = 120/100 = 1.2
d = 90/100 = 0.9
T = 0.5 rT = 0.03 · 0.5 = 0.015
Exercise 2 (Cont.) 13

K = S0 = 100 rT = 0.015
Cu = 20 Cd = 0
u = 1.2 d = 0.9
Cu − Cd 20 − 0 2
b= = =
(u − d)S0 (1.2 − 0.9)100 3
 
u d
a = e −rT Cd − Cu
u−d u−d
 
−0.015 1.2 0.9
=e ·0− · 20 = −59.107
1.2 − 0.9 1.2 − 0.9
2
a + bS0 = −59.107 + · 100 = 7.56
 3 0.015 0.015

e − 0.9 1.2 − e
or : v (0) = e −0.015 20 · +0· = 7.56
1.2 − 0.9 1.2 − 0.9