Derivative Securities

Chapter 10

Introduction to Binomial Trees

FIN 480 (Instructor- Saif Rahman)

A Simple Binomial Model

A stock price is currently $20 In three months it will be either $22 or $18

Stock Price = $22

Stock price = $20

Stock Price = $18

FIN 480 (Instructor- Saif Rahman)

A Call Option (Figure 11.1, page 248)

A 3-month call option on the stock has a strike price of 21.

Stock Price = $22 Option Price = $1

Stock price = $20 Option Price=?

Stock Price = $18 Option Price = $0

FIN 480 (Instructor- Saif Rahman)

Setting Up a Riskless Portfolio

Consider the Portfolio: long shares short 1 call option

22 1

18 Portfolio is riskless when 22 1 = 18 = 0.25

or

FIN 480 (Instructor- Saif Rahman)

Valuing the Portfolio (Risk-Free Rate is 12%)

The riskless portfolio is: long 0.25 shares short 1 call option

The value of the portfolio in 3 months is 22 0.25 1 = 4.50

The value of the portfolio today is 4.5e 0.12 0.25 = 4.3670

FIN 480 (Instructor- Saif Rahman)

Generalization (Figure 11.2, page 249)

A derivative lasts for time T and is dependent on a stock

Su u

Sd d
FIN 480 (Instructor- Saif Rahman)

Generalization (continued)

Consider the portfolio that is long

shares and short 1 derivative

Su u

Sd d

The portfolio is riskless when Su u = Sd

d or

u Su
6

fd Sd
FIN 480 (Instructor- Saif Rahman)

Generalization (continued)

Value of the portfolio at time T is

Su

Value of the portfolio today is f (Su u )erT

(Su

u )erT

Another expression for the portfolio value today is S Hence = S

FIN 480 (Instructor- Saif Rahman)

Generalization (continued)

Substituting for

we obtain

= [ p u + (1 p )d ]erT

where

e u

rT

d d
FIN 480 (Instructor- Saif Rahman)

Risk-Neutral Valuation

= [ p u + (1 p )d ]e-rT The variables p and (1 p ) can be interpreted as the risk-neutral probabilities of up and down movements The value of a derivative is its expected payoff in a risk-neutral world discounted at the risk-free rate

S
9

Su u
Sd d
FIN 480 (Instructor- Saif Rahman)

Original Example Revisited

Su = 22 u = 1 S Sd = 18 d = 0

Since p is a risk-neutral probability -20e0.12 0.25 = 22p + 18(1 p ); p = 0.6523 Alternatively, we can use the formula

e rT d u d

e 0.12 0.25 0.9 1.1 0.9

0.6523

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FIN 480 (Instructor- Saif Rahman)

Valuing the Option

Su = 22 u = 1 S
The value of the option is e0.12 0.25 [0.6523 1 + 0.3477 0] = 0.633

Sd = 18 d = 0

11

FIN 480 (Instructor- Saif Rahman)

Valuing a Call Option

Figure 11.4, page 253
D

22

24.2 3.2

B E

20 1.2823

2.0257 18
C

19.8 0.0 16.2 0.0

0.0

Value at node B = e0.12 0.25(0.6523 3.2 + 0.3477 0) = 2.0257 Value at node A = e0.12 0.25(0.6523 2.0257 + 0.3477 0) = 1.2823

Each time step is 3 months K=21, r=12%

FIN 480 (Instructor- Saif Rahman)

12

A Put Option Example; K=52

Figure 11.7, page 256

K = 52, t = 1yr r = 5%
60
50 4.1923
A

72 0

B
E

1.4147 40
C

48 4 32 20

9.4636
F

13

FIN 480 (Instructor- Saif Rahman)

What Happens When an Option is American

(Figure 11.8, page 257)
72 0
48 4 32 20

60
50 5.0894
A

B E

1.4147 40
C

12.0
F

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FIN 480 (Instructor- Saif Rahman)

Delta

= Delta = Change in price of the option/Change in price of the stock = Number of units of the stock that are held for each call option shorted to create a risk free hedge

15

The value of

varies from node to node

FIN 480 (Instructor- Saif Rahman)

Choosing u and d
One way of matching the volatility is to set
u d e 1 u
t

where is the volatility and t is the length of the time step. This is the approach used by Cox, Ross, and Rubinstein

16

FIN 480 (Instructor- Saif Rahman)

The Probability of an Up Move

a d p u d a e r t for a nondividen d paying stock a a e(r e
q) t

for a stock index wher e q is the dividend for a currency where r f is the foreign

yield on the index

(r rf ) t

risk - free rate a 1 for a futures contract

17

FIN 480 (Instructor- Saif Rahman)