Implied Transition Probabilities: Autumn 2 0 0 9

A U T U M N
2 0 0 9
IMPLIED TRANSITION PROBABILITIES
Numerical Methods in Finance (Implementing Market Models)

COMPUTATIONAL FINANCE
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©Finbarr Murphy 2007
Lecture Objectives
 Implied Transition Probabilities
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Agenda
Page
Implied Transition Probabilities 2

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Implied Transition Probabilities

 The implied transition probabilities can now be
computed from the state prices
 We start with some basic premises

j+1
Pu ,i , j  Pm ,i , j  Pd ,i , j  1
Pu,i,j
Pm,i,j
j
Pd,i,j
j-1
i+1
i
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 We also assume that the current price of a stock
must be equal to
1. The sum of the expected values times the probabilities
2. Discounted at the risk free rate Si+1,j+1
Pu,i,j
 rt  Pu ,i , j Si 1, j 1  ... 

Si , j  e P S 
 m , i , j i 1, j  Pd , i , j S i 1, j 1  S
i,j
Pm,i,j
Si+1,j
Pd,i,j
Si+1,j-1
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 Finally, the forward evolution of the state price
must be consistent
 Pu ,i , j Qi , j  ...  Qi,j+2 Qi+1,j+2
 rt  
Qi 1, j 1  e  Pm ,i , j 1Qi , j 1  ... 
Pd,i,j+2
P Q 
 d ,i , j  2 i , j  2 
Pm,i,j+1
Qi,j+1 Qi+1,j+1
Pu,i,j
 This can be rearranged as Qi,j Qi+1,j
e rt Qi 1, j 1  Pm ,i , j 1Qi , j 1  Pd ,i , j  2Qi , j  2

Pu ,i , j 
Qi , j
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 The other probabilities are:
e Si , j  Si 1, j 1  Pu ,i , j  Si 1, j 1  Si 1, j 1 

rt
Pm ,i , j 
Si 1, j  Si 1, j 1
Pd ,i , j  1  pm ,i , j  pu ,i , j
 These probability equations suggest that if we know

future probabilities (above node i,j), we can
calculate current values
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 So using our “simple” 2-step Q2,2
j=2
structure, the probability Pu,1,1 is Pu,1,1
Δx
calculated as j=1
Q1,1 Pm,1,1 Q2,1
rt
e Q2 , 2 Δx Pu,0,0
Pd,1,1
Pu ,1,1  j=0 Q2,0
Q1,1 Δx
j=-1
Δx
 Or, in a general sense we can
j=-2
say:
i=0 i=1 i=2

Δt1 Δt2
rt
e Qi 1,i 1
Pu ,i , j 
Qi ,i
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 Using the previous equations, Q2,2
j=2
we can calculate Pm,1,1 and Pd,1,1 Pu,1,1
Δx
Q1,1 Pm,1,1 Q2,1
j=1
 So, in the same way top-right- Pd,1,1
Δx Pu,0,0
down manner as we calculated j=0 Q2,0
the state prices, we can Δx

calculate the transition j=-1
probabilities Δx
j=-2
i=0 i=1 i=2

 We also move down to the Δt1 Δt2
centre and up to the centre

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 To ensure that the transition probabilities remain
positive and the explicit finite difference methods
stability condition
x   3t
 Is satisfied, we need to calculate the local
volatility at each node
 We can do this using the formula:

var x    2
local  
t  E x   E  x  
2 2
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 Time to look at some code again. We’ll continue
with the example from C&S page 143
 Recall:
 S = 100
 T=1
 R = 6%
 N=4
 Δx = 0.2524
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 Here is the code to work down through the
transition probabilities
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 Here are the full implied probabilities
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 The code to implement the implied state prices
and implied transition probabilities is reasonably
complex
 But the advantages of such an implied tree are

many
 To illustrate, we will briefly look at an exotic

option and apply our implied tree
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 We consider the family of barrier options
 Down and in call or put
 Down and out call or put
 Up and in call or put
 Up and out call or put
 These options are activated (=“in”) if the asset

price is below (=“down”) or above (=“up”) a
predetermined level during specified dates
 These options are de-activated (=“out”) if the

asset price is below (=“down”) or above (=“up”) a
predetermined level during specified dates
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 Some analytical solutions are available for these
options but these solutions are limited
 We could use Monte Carlo methods or
 We could apply the implied tree results to the

pricing of the option.
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 Consider an American Up-An-Out Put option
 This gives the holder the right to sell an asset at

any time unless the asset price has breached a
barrier during a specified time period
 The following graph shows three possible paths

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 Path 1
2
3 finishes out-of-the-money
in-the-money and and so expires
did not breach
broke the
worthless
the barrier barrier
up-and-out so pays H
max(K-S T,0) worthless
so expires
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 The mathematical representation for this
particular option is
max 0, K  ST  |min( St 1 ,..., Stm ) H

 Using the same stock price processes as per the
examples in C&S, we can see what the option
values at maturity will be
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 Look again at the stock price trinomial tree
 What are the terminal option values if K = 100

and H = 110?
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 The final nodes are easy to calculate
max 0, K  ST 
 What is the value of the option at C3,-2?

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 The first check is to see if the value of the stock
at 3,-2 is greater than the barrier, H
If (S3,-2 > H)
C3,-2 = 0
else
max 0, K  ST 
continue …
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 We have calculated the implied transition
probabilities from a standard option price, so we
can use these here
 For node 3,-2, these were
Pu,3,-2
Pm,3,-2
Pd,3,-2
 Therefore, the option at 3,-2 is given by the

discounted expectation
C3, 2  e  rt
p
u , 3, 2 C4 , 1  pm ,3, 2C4 , 3  pd ,3, 2C4 , 3 
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 This given an option value of
C3,-2 = 38.1486
 Now apply early exercise conditions
 C3,-2 = max(C3,-2,K - S3,-2);
 = max(38.1486, 100-60.3626)
 = 39.6374
 So early exercise is optimal at this point

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 To summarise:
 We have seen how implied trinomial trees can be

constructed from standard option market data
 Using various maturity options along with

interpolation, we can construct an implied state
and probability transition tree
 Using this data, we can calculate the price of

more exotic options where analytical solutions

are unavailable
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Recommended Texts
 Required/Recommended
 Clewlow, L. and Strickland, C. (1996) Implementing derivative
models, 1st ed., John Wiley and Sons Ltd.
— Chapter 5
 Additional/Useful
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Implied Transition Probabilities: Autumn 2 0 0 9

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A U T U M N

IMPLIED TRANSITION PROBABILITIES

Numerical Methods in Finance (Implementing Market Models)

Implied Transition Probabilities 2

Implied Transition Probabilities

 We start with some basic premises

Implied Transition Probabilities

 rt  Pu ,i , j Si 1, j 1  ... 

Implied Transition Probabilities

 Pu ,i , j Qi , j  ...  Qi,j+2 Qi+1,j+2

 This can be rearranged as Qi,j Qi+1,j

e rt Qi 1, j 1  Pm ,i , j 1Qi , j 1  Pd ,i , j  2Qi , j  2

Implied Transition Probabilities

e Si , j  Si 1, j 1  Pu ,i , j  Si 1, j 1  Si 1, j 1 

 These probability equations suggest that if we know

Implied Transition Probabilities

Pu ,1,1  j=0 Q2,0

i=0 i=1 i=2

Implied Transition Probabilities

the state prices, we can Δx

i=0 i=1 i=2

centre and up to the centre

Implied Transition Probabilities

 We can do this using the formula:

Implied Transition Probabilities

Implied Transition Probabilities

Implied Transition Probabilities

Implied Transition Probabilities

 But the advantages of such an implied tree are

 To illustrate, we will briefly look at an exotic

Implied Transition Probabilities

 These options are activated (=“in”) if the asset

predetermined level during specified dates

 These options are de-activated (=“out”) if the

Implied Transition Probabilities

 We could use Monte Carlo methods or

 We could apply the implied tree results to the

Implied Transition Probabilities

 This gives the holder the right to sell an asset at

 The following graph shows three possible paths

Implied Transition Probabilities

Implied Transition Probabilities

max 0, K  ST  |min( St 1 ,..., Stm ) H

Implied Transition Probabilities

 What are the terminal option values if K = 100

Implied Transition Probabilities

 What is the value of the option at C3,-2?

Implied Transition Probabilities

Implied Transition Probabilities

 For node 3,-2, these were

 Therefore, the option at 3,-2 is given by the

Implied Transition Probabilities

 Now apply early exercise conditions

 C3,-2 = max(C3,-2,K - S3,-2);

 So early exercise is optimal at this point

Implied Transition Probabilities

 We have seen how implied trinomial trees can be

 Using various maturity options along with

 Using this data, we can calculate the price of

more exotic options where analytical solutions

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