Two period Binomial Option (European-style) Pricing Model (BOPM)

 In the single period BOPM only allows for two points in time i.e. initiation and
expiration), therefore, there are only two possible future stock prices at
expiration i.e. Su and Sd.
 In two periods BOPM has three time points i.e. today or time 0 (initiation
date), time 1 (the mid-point between initiation and expiration), and time 2
(expiration).
 The price of underlying asset (stock) moves up and down in each sub-period
until expiration ( i.e. So, Su, Sd, Su2, Sud, and Sd2)
 A two-period allows us to use BOPM for both European and American styles
of option

Valuation of Two-period Binomial call option

Step 1: setting up stock price path:-
Step 2: setting up call price path and calculation of intrinsic value of call at
expiration (t2):-

Cu2 = Max (o, Su2 – E)

Cud = Max (o, Sud – E)

Cd2 = Max (0, Sd2 – E)

Step 3: calculation probability:-

(1+𝑟)𝑡 −𝑑
Pr =
𝑢−𝑑
𝑒 𝑟𝑐𝑥𝑡
=
𝑢−𝑑
Step 4: calculation of value of call at time t 1:-
𝑃𝑟𝑥𝐶𝑢2 +(1−𝑃𝑟)𝑥 𝐶𝑢𝑑
Cu =
(1+𝑟)
𝑃𝑟𝑥𝐶𝑢2 +(1−𝑃𝑟)𝑥 𝐶𝑢𝑑
or =
𝑒 𝑟𝑐𝑥𝑡

𝑃𝑟 𝑥 𝐶𝑢𝑑+(1−𝑝𝑟)𝑥𝐶𝑑 2
Cd = (1+𝑟)

𝑃𝑟 𝑥 𝐶𝑢𝑑+(1−𝑝𝑟)𝑥𝐶𝑑 2
=
𝑒 𝑟𝑐𝑥𝑡
Step 5:- Calculation of theoretical fair value of call:-
𝑃𝑟 𝑥 𝐶𝑢+(1−𝑝𝑟)𝑥𝐶𝑑
C= (1+𝑟)𝑜𝑟 𝑒 𝑟𝑐𝑥𝑡

Valuation of Two-period Binomial Put option

Step 1: setting up stock price path:-

Step 2: setting up Put price path and calculation of intrinsic value of Put at
expiration (t2):-
 Pu2 = Max (o, E - Su2 )

Pud = Max (o, E - Sud)

Pd2 = Max (0, E - Sd2 )

Step 3: calculation probability:-

(1+𝑟)𝑡 −𝑑
Pr =
𝑢−𝑑
𝑒 𝑟𝑐𝑥𝑡
=
𝑢−𝑑

Step 4: calculation of value of call at time t 1:-

𝑃𝑟𝑥𝑃𝑢2 +(1−𝑃𝑟)𝑥 𝑃𝑢𝑑
Cu =
(1+𝑟)
𝑃𝑟𝑥𝑃𝑢2 +(1−𝑃𝑟)𝑥 𝑃𝑢𝑑
or =
𝑒 𝑟𝑐𝑥𝑡

𝑃𝑟 𝑥 𝑃𝑢𝑑+(1−𝑝𝑟)𝑥𝑃𝑑 2
Pd = (1+𝑟)

𝑃𝑟 𝑥 𝑃𝑢𝑑+(1−𝑝𝑟)𝑥𝑃𝑑 2
=
𝑒 𝑟𝑐𝑥𝑡

Step 5:- Calculation of theoretical fair value of Put:-

𝑃𝑟 𝑥 𝑃𝑢+(1−𝑝𝑟)𝑥𝑃𝑑
P= (1+𝑟)𝑜𝑟 𝑒 𝑟𝑐𝑥𝑡

Hedge Ratio
Call hedge Ratio

 Hedge ratio (h) express that the value of portfolio will be unaffected by
stock price change, if the investor write(short) call and buy stock or long call
and short sell the stock.

(i) Initial hedge ratio :

 𝐶𝑢 − 𝐶𝑑
h=
𝑆𝑢−𝑆𝑑
(ii) Two possible hedge ratio
 When stock price goes up to Su :
𝐶𝑢2 − 𝐶𝑢𝑑
hu =
𝑆𝑢2 − 𝑆𝑢𝑑
 When stock price goes up to Sd :
𝐶𝑢𝑑−𝐶𝑑 2
hd =
𝑆𝑢𝑑−𝑆𝑑 2

Put hedge Ratio

 Hedge ratio (h) express that the value of portfolio will be unaffected by
stock price change, if the investor write(short)put and short sell stock or
long put and buy the stock.
(i) Initial hedge ratio :
𝑃𝑢 − 𝑃𝑑
h=
𝑆𝑢−𝑆𝑑
(ii) Two possible hedge ratio
 When stock price goes up to Su :
𝑃𝑢2 − 𝑃𝑢𝑑
hu =
𝑆𝑢2 − 𝑆𝑢𝑑
 When stock price goes up to Sd :
𝑃𝑢𝑑−𝑃𝑑 2
hd =
𝑆𝑢𝑑−𝑆𝑑 2