Introduction to

Binomial Trees

Chapter 11

1
 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

2
 A Call Option
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

3
Setting Up a Riskless Portfolio
 Consider the Portfolio: long D shares
short 1 call option

22D – 1

18D
 Portfolio is riskless when 22D – 1 = 18D or
D = 0.25

4
 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

5
 Valuing the Option
 The portfolio that is
long 0.25 shares
short 1 option
is worth 4.367
 The value of the shares is
5.000 (= 0.2520 )
 The value of the option is therefore
0.633 (= 5.000 – 4.367 )

6
 Generalization
 A derivative lasts for time T and is
dependent on a stock

S0 u
ƒu
S0
ƒ S0d
ƒd
7
 Generalization
(continued)

 Consider the portfolio that is long D shares and short

1 derivative S0 uD – ƒu
DS0– f
S0dD – ƒd

 The portfolio is riskless when S0uD – ƒu = S0d D – ƒd

or
ƒu  f d
D
S0 u  S0 d
8
 Generalization
(continued)
 Value of the portfolio at time T
is S0u D – ƒu
 Value of the portfolio today is
(S0u D – ƒu )e–rT
 Another expression for the
portfolio value today is S0D – f
 Hence
ƒ = S0D – (S0u D – ƒu )e–rT
9
 Generalization
(continued)

 Substituting for D we obtain

ƒ = [ p ƒu + (1 – p )ƒd ]e–rT

where
e d rT
p
ud

10
 Risk-Neutral Valuation
 ƒ = [ p ƒu + (1 – p )ƒd ]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
S0u
ƒu
S0
ƒ S0d
ƒd
11
Irrelevance of Stock’s Expected
Return

When we are valuing an option in terms

of the underlying stock the expected
return on the stock is irrelevant

12
Original Example Revisited
S0u = 22
ƒu = 1
S0
ƒ
S0d = 18
ƒd = 0
 Since p is a risk-neutral probability:
20 = [22p + 18(1 – p )] e-0.12 0.25 ; Solve for p:
p = 0.6523
 Alternatively, we can use the formula

e rT  d e 0.120.25  0.9
p   0.6523
ud 1.1  0.9

13
 Valuing the Option
S0u = 22
ƒu = 1
S0
ƒ
S0d = 18
ƒd = 0

The value of the option is

e–0.120.25 [0.65231 + 0.34770]
= 0.633
14
 Risk-Neutral vs Real World
 In risk-neutral world anything earns the risk-free rate
of return and the probabilities of price movements are
different from those in the real world.
 Assume the stock from previous slide earns an
expected return µ = 16%. Then, by definition:

E [ ST ]
ln  T
S0 Real world probability
S0  20
E [ ST ]  22 q  18(1  q )
Thus,
22 q  18(1  q )
ln  0.16 * 3 / 12  q  0.7041
20
15
 Risk-Neutral vs Real World
 In the case of the call option it means that the
expected option payoff is $0.7041 and, hence,
the expected option return (implied from that
of the stock) is 42.58%. Here is the algebra:
E [CT ]
ln   cT
C0
C0  0.633
E [CT ]  1 * q  0 * (1  q )  $0.7041
Thus,
0.7041
ln  c * 3 / 12  c  42.58%
0.633
16
A Two-Step Example
24.2
22

20 19.8

18
16.2
 Each time step is 3 months

17
 Valuing a Call Option
24.2
D
3.2
22
B
20 2.0257 19.8
A E
1.2823 0.0
18
C
0.0 16.2
F 0.0
 Value at node B
= e–0.120.25(0.65233.2 + 0.34770) = 2.0257
 Value at node A
= e–0.120.25(0.65232.0257 + 0.34770)
= 1.2823

18
A Put Option Example; K=52
r = .05, T=2 years

72
D
0
60
B
50 1.4147 48
A E
4.1923 4
40
C
9.4636 32
F 20

19
 What Happens When the Put
from Previous Slide is American
72
D
0
60
B
50 1.4147 48
A E
5.0894 4
40
C
12.0 32
F 20
At each node choose either the continuation value or the
exercise value, whichever is higher.

20
 Delta
 Delta (D) is the ratio of the change in the price
of a stock option to the change in the price of
the underlying stock
 The value of D varies from node to node
 Think of D as the number of shares that one
needs to sell short to hedge one long call option.
The change in the value of this portfolio from
node to node is zero:
 C - D S = (1-0) – 0.25(22-18) = 0
 Delta changes over time which gives rise to
dynamic hedging strategies

21
 Computation of Delta
 In practice, compute delta as follows:
Su=25, fu=5

Sd=15, fd=0
 Delta is then:

f fu  fd 50
D    0.5
S Su  Sd 25  15
 Call Delta is positive. What about puts?

22
 Choosing u and d in practice
One way of matching the volatility is to set
s t
ue
d  e s t

where s is the volatility and t is the

length of the time step. This is the
approach used by Cox, Ross, and
Rubinstein
23
 Example
 A stock price is currently $25. The standard deviation of
the stock return is 20% per year and the risk-free rate is
10% per year (continuous). What is the value of the
2
derivative that pays $ ST in t=T=2 months? (We’ll use
one period tree for simplicity)

u  es t  e.2 2 / 12  1.08508
1
d   0.92159
u
e rT  d
p  0.5824
ud
V  ( pVu  (1  p )Vd )e rT  $639.5
24
 Value a Forward
 Given the data on the previous slide value a
two-month forward on the stock. Delivery price
K is $20.
 From before you remember that
 f0 = S0 – Ke-rT = 25 – 20e-0.1x2/12 = 5.33

 Using risk neutral valuation:

 fu = Su – K = 27.127 – 20 = 7.127

 fd = Sd – K = 23.040 – 20 = 3.040

 f0 = [p fu + (1-p) fd)] e-rT =

= [0.5824x7.127+0.4176x3.040]e-0.1x2/12 = 5.33
25