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Introduction To Binomial Trees
Introduction To Binomial Trees
Binomial Trees
Chapter 12
12.1
Goals of Chapter 12
12.2
12.1 One-Period Binomial
Tree Model
12.3
One-Period Binomial Tree Model
= 22
= 20
= 18
12.5
One-Period Binomial Tree Model
22D 1
18D
12.9
Generalization of One-Period
Binomial Tree Model
Consider any derivative lasting for time T
and its payoff is dependent on a stock
=
=
Assume that the possible stock price at are
= and = , where and are
constant multiplication factors for the upper and
lower branches
and are payoffs of the derivative
corresponding to the upper and lower branches 12.10
Generalization of One-Period
Binomial Tree Model
Construct Portfolio P that longs D shares and
shorts 1 derivative. The payoffs of Portfolio P are
Portfolio P is riskless if = and
thus
=
Recall that in the prior numerical example, = 20, =
1.1, = 0.9, = 1, and = 0, so the solution of for
generating a riskless portfolio is 0.25 12.11
Generalization of One-Period
Binomial Tree Model
Value of Portfolio P at time T is (or
equivalently )
Value of Portfolio P today is thus ( )
The initial investment (or the cost) for Portfolio P is
Hence = ( )
Substituting for in the above equation,
we obtain
= [ + 1 ],
where =
12.12
12.2 Risk-Neutral Valuation
Relationship (
)
12.13
Risk-Neutral Valuation
Relationship ()
Risk-averse (), risk-neutral (),
and risk-loving () behaviors
A game of flipping a coin
For risk-averse investors, they accept a risky game if its
expected payoff is higher than the payoff of the riskless
game by a required amount which can compensate
investors for the risk they take
That is, risk-averse investors requires compensation for risk
For different investors, they have different tolerance for risk,
i.e., they require different expected payoff to accept the same
risky game
12.14
Risk-Neutral Valuation
Relationship ()
For risk-neutral investors, they accept a risky game even if
its expected payoff equals the payoff of the riskless game
That is, they care about only the levels of the (expected)
payoffs
In other words, they require no compensation for risk
For risk-loving investors, they accept a risky game to
enjoy the feeling of gamble even if its expected payoff is
lower than the payoff of the riskless game
That is, they would like to sacrifice some benefit for entering a
risky game
12.15
Risk-Neutral Valuation
Relationship ()
In a risk-averse financial market, securities with
higher degree of risk need to offer higher expected
returns
So, our real world is a risk averse world, i.e., most
investors are risk averse and require compensation for
the risk they tolerate
In a risk-neutral financial market, the expected
returns of all securities equal the risk free rate
regardless of their degrees of risk
That is, even for derivatives, their expected returns equal
the risk free rate in the risk-neutral world
In a risk-loving financial market, securities with
higher degree of risk offer lower expected returns
12.16
Risk-Neutral Valuation
Relationship ()
Interpret in = [ + 1 ] as a
probability in the risk-neutral world
If the expected return of the stock price is in the
real world (a risk averse world), the expected stock
price at the end of the period is =
+ 1 = =
12.17
Risk-Neutral Valuation
Relationship ()
Comparing with = it is natural to interpret
,
and 1 as probabilities of upward and downward
movements in the risk-neutral world
This is because that the expected return of any security in
the risk-neutral world is the risk free rate
The formula = [ + 1 ] is consistent
with the general rule to price derivatives
Note that in the risk-neutral world, [ + 1 ] is the
expected payoff of a derivative and is the correct
discount factor to derive the PV today
The complete version of the general derivative pricing
method is that any derivative can be priced as the PV of its
expected payoff in the risk-neutral world 12.18
Risk-Neutral Valuation
Relationship ()
Risk-neutral valuation relationship (RNVR)
It states that any derivative can be priced with the
general derivative pricing rule as if it and its
underlying asset were in the risk-neutral world
Since the expected returns of both the derivative
and its underlying asset are the risk free rate
The probability of the upward movement in the prices of
the underlying asset is =
The discount rate for the expected payoff of the
derivative is also
When we are evaluating an option on a stock, the
expected return on the underlying stock, , is irrelevant
12.19
Risk-Neutral Valuation
Relationship ()
Revisit the original numerical example in the
risk-neutral world
= 22
= 1
= 20
=?
= 18
= 0
12%0.25 0.9
Calculate = = = 0.6523
1.10.9
Calculate the option value according to the RNVR
12%0.25 0.6523 1 + 1 0.6523 0 = 0.633
12.20
12.3 Multi-Period Binomial
Tree Model
12.21
Two-Period Binomial Tree Model
24.2
22 Note the recombined
feature can limit the
growth of the number of
20 19.8
nodes on the binomial
tree in a acceptable
18 manner
16.2
Values of the parameters of the binomial tree
= 20, = 12%, = 1.1, = 0.9, = 0.5, the
number of time steps is = 2, and thus the length
of each time step is = / = 0.25
Hence, the risk-neutral probability = =
12%0.25 0.9
= 0.6523 12.22
1.10.9
Two-Period Binomial Tree Model
node B node D
22 24.2
2.0257 3.2
node A node E
20 19.8
1.2823 0
node C
18 node F
16.2
0
0
For a European call option with the strike price to be
21, perform the backward induction method (
) recursively on the binomial tree
Option value at node B: 12%0.25 0.6523 3.2 + 0.3477 0 =
2.0257
Option value at node C: 12%0.25 0.6523 0 + 0.3477 0 = 0
Option value at node A (the initial or root node):
12%0.25 0.6523 2.0257 + 0.3477 0 = 1.2823 12.23
Two-Period Binomial Tree Model
node D
node B
60 72
1.4147 0
node A node E
50 48
4.1923 4
node C node F
40 32
9.4636 20
12.25
Delta
Delta ()
The formula to calculate in the binomial tree
model is on Slide 12.11
In the binomial tree model, is the number of shares of
the stock we should hold for each option shorted in order
to create a riskless portfolio
For the one-period example on Slide 12.6, the delta of the
10
call option is = 0.25
2218
Theoretically speaking, is defined as the ratio of
the change in the price of a stock option with
respect to the change in the price of the underlying
stock, i.e., = 12.26
Delta
node A node E
20 19.8
1.2823 0
node C
18 node F
16.2
0
0
2.02570
at node A: = 0.5064
2218
3.20
at node B: = 0.7273
24.219.8
00
at node C: =0 12.28
19.816.2
Delta
12.29
CRR Binomial Tree Model
+
2
var + = + [+ ]2
2 2 = 2 2 + 1 2 2 ( )2
2 = 2 + 1 2 2 12.30
CRR Binomial Tree Model
With = and the assumption of = 1
= and =
This method is first proposed by Cox, Ross, and
Rubinstein (1979), so this method is also known
as the CRR binomial tree model
The validity of the CRR binomial tree model depends on
the risk-neutral probability being in [0,1]
In practice, the life of the option is typically partitioned
into hundreds time steps
First, ensure the validity of the risk-neutral probability, ,
which approaches 0.5 if approaches 0
Second, ensure the convergence to the BlackScholes
model (introduced in Ch. 13) 12.31
12.4 Dividend Yield in the
Binomial Tree Model
12.32
The Effect of Dividend Yield on
Risk-Neutral Probabilities
+ =
+
In the risk-neutral world, the total return from dividends and
capital gains is
If the dividend yield is , the return of capital gains in the stock
price should be
()
Hence, + 1 = =
The dividend yield does NOT affect the volatility of the stock
price and thus does NOT affect the multiplying factors and
So, = and = in the CRR model still can be used
12.33