Binomial Models

Dr. San-Lin Chung

Department of Finance
National Taiwan University
In this lecture, I will cover the following topics:
1. Brief Review of Binomial Model
2. Extensions of the binomial models in the
literature
3. Fast and accurate binomial option models
4. Binomial models for pricing exotic options
5. Binomial models for other distributions or
processes
1. Brief Review of Binomial Trees

• Binomial trees are frequently used to

approximate the movements in the price
of a stock or other asset
• In each small interval of time the stock
price is assumed to move up by a
proportional amount u or to move down
by a proportional amount d
The main idea of binomial option pricing theory
is pricing by arbitrage. If one can formulate a
portfolio to replicate the payoff of an option,
then the option price should equal to the price
of the replicating portfolio if the market has no
arbitrage opportunity.

Binomial model is a complete market model, i.e.

options can be replicated using stock and risk-
free bond (two states next period, two assets).
On the other hand, trinomial model is not a
complete market model.
Generalization (Figure 10.2, page 202)

• A derivative lasts for time T and is

dependent on a stock

S0 u
ƒu
S0
ƒ S0d
ƒd
 Generalization
(continued)

• Consider the portfolio that is long  shares and short

1 derivative S0 u– ƒu

S0–
S0d– ƒd
f
• The portfolio is riskless when S0u– ƒu = S0d – ƒd or

ƒu  f d

S0 u  S0 d
 Generalization
(continued)
• Value of the portfolio at time T is
S0u – ƒu
• Value of the portfolio today is
(S0u  – ƒu )e–rT
• Another expression for the
portfolio value today is S0– f
• Hence ƒ = S0– (S0u – ƒu )e–rT
 Generalization
(continued)

• Substituting for  we obtain

ƒ = [ p ƒu + (1 – p )ƒd ]e–rT

where
e d rT
p
ud
 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
p ƒu
S0
ƒ ( S0d
1–
p) ƒd
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
Movements in Time t
(Figure 18.1)

p Su

S
1–
p Sd
 Tree Parameters for a
Nondividend Paying Stock
• We choose the tree parameters p, u, and d
so that the tree gives correct values for the
mean & standard deviation of the stock
price changes in a risk-neutral world
er t = pu + (1– p )d
2t = pu 2 + (1– p )d 2 – [pu + (1– p )d ]2

• A further condition often imposed is u = 1/ d

 2. Tree Parameters for a
Nondividend Paying Stock
(Equations 18.4 to 18.7)

When t is small, a solution to the equations is

u  e t

d  e  t

ad
p
ud
a  e r t
 The Complete Tree
(Figure 18.2)

S0u3 S0u4
S0u2
S0u S0u S0u2
S0
S0 S0d S0
S0d
S0d2
S0d2
S0d3

S0d4
 Backwards Induction

• We know the value of the option

at the final nodes
• We work back through the tree
using risk-neutral valuation to
calculate the value of the option
at each node, testing for early
exercise when appropriate
 Example: Put Option

S0 = 50; X = 50; r =10%;  = 40%;

T = 5 months = 0.4167;
t = 1 month = 0.0833
The parameters imply
u = 1.1224; d = 0.8909;
a = 1.0084; p = 0.5076
Example (continued)
Figure 18.3 89.07
0.00
79.35
0.00
70.70 70.70
0.00 0.00
62.99 62.99
0.64 0.00
56.12 56.12 56.12
2.16 1.30 0.00
50.00 50.00 50.00
4.49 3.77 2.66
44.55 44.55 44.55
6.96 6.38 5.45
39.69 39.69
10.36 10.31
35.36 35.36
14.64 14.64
31.50
18.50
28.07
21.93
 Trees and Dividend Yields
• When a stock price pays continuous dividends
at rate q we construct the tree in the same way
but set a = e(r – q )t
• As with Black-Scholes:
– For options on stock indices, q equals the
dividend yield on the index
– For options on a foreign currency, q equals
the foreign risk-free rate
– For options on futures contracts q = r
Binomial Tree for Dividend
Paying Stock

• Procedure:
– Draw the tree for the stock price less the
present value of the dividends
– Create a new tree by adding the present
value of the dividends at each node
• This ensures that the tree recombines and makes
assumptions similar to those when the Black-
Scholes model is used
 II. Literature Review (1/5)
There have been many extensions of the CRR model.
The extensions can be classified into five
directions.
The first direction consists in modifying the lattice to
improve the accuracy and computational efficiency.
Boyle (1988)
Breen (1991)
Broadie and Detemple (1996)
Figlewski and Gao (1999)
Heston and Zhou (2000)
 II. Literature Review (2/5)
The second branch of the binomial OPM literature
has incorporated multiple random assets.
Boyle (1988)
Boyle, Evnine, and Gibbs (1989)
Madan, Milne, and Shefrin (1989)
He (1990)
Ho, Stapleton, and Subrahmanyam (1995)
Chen, Chung, and Yang (2002)
 II. Literature Review (3/5)

The third direction of extensions consists in showing

the convergence property of the binomial OPM.

Cox, Ross, and Rubinstein (1979)

Amin and Khanna (1994)
He (1990)
Nelson and Ramaswamy (1990)
 II. Literature Review (4/5)

The fourth direction of the literature generalizes the

binomial model to price options under stochastic
volatility and/or stochastic interest rates.
Stochastic interest rate: Black, Derman, and Toy
(1990), Nelson and Ramaswamy (1990), Hull and
White (1994), and others.
Stochastic volatility: Amin (1991) and Ho, Stapleton,
and Subrahmanyam (1995) Ritchken and Trevor
(1999)
 II. Literature Review (5/5)

The fifth extension of the CRR model focus on

adjusting the standard multiplicative-binomial
model to price exotic options, especially
path-dependent options.
Asian options: Hull and White (1993) and Dai
and Lyuu (2002).
Barrier options: Boyle and Lau(1994),
Ritchken (1995), Boyle and Tian (1999), and
others.
3. Alternative Binomial Tree
3.1 Jarrow and Rudd (1982)
Instead of setting u = 1/d we can set
each of the 2 probabilities to 0.5 and
( r   2 / 2 ) t   t
ue
( r   2 / 2 ) t   t
d e
 3.2 Trinomial Tree (Page 409)
 t
ue
Su
m 1
  t pu
d e

pu 

u  M  M   M  1
2
 S
pm
S

 u  1 u  1
2

pm  1  Pu  Pd pd

pd 
u2  M 2

 M  u 3  M  1

 u  1 u 2  1  Sd
 3.3 Adaptive Mesh Model
• This is a way of grafting a high resolution
tree on to a low resolution tree
• We need high resolution in the region of
the tree close to the strike price and option
maturity
 3.4 BBS and BBSR

The Binomial Black & Scholes (BBS) method is

proposed by Broadie and Detemple (1996). The
BBS method is identical to the CRR method, except
that at the time step just before option maturity the
Black and Scholes formula replaces at all the nodes.
 3.5 Tian (1999)(1/3)
The second method was put forward by Tian(1999) termed
“flexible binomial model”. To construct the so-called
flexible binomial model, the following specification is
proposed:
rt
e d
 7
2 2
 t   t  t   t
ue ,d  e ,p
ud
where λ is an arbitrary constant, called the “tilt
parameter”. It is an extra degree of freedom over the
standard binomial model. In order to have “nonnegative
probability”, the tilt parameter must satisfy the inequality
(8)
after jumps, u and d, are redefined.
 3.6 Heston and Zhou (2000)
Heston and Zhou (2000) show that the accuracy or rate of
convergence of binomial method depend, crucially on the
smoothness of the payoff function. They have given an
approach that is to smooth the payoff function. Intuitively,
if the payoff function at singular points can be smoothing,
the binomial recursion might be more accurate. Hence they
let G(x) be the smoothed one;
1 x
G X    g  x  y  dy
2 x  x

where g(x) is the actual payoff function.

3.7 Leisen and Reimer (1996)
3.7 Leisen and Reimer (1996)
3.8 WAND (2002, JFM)
 3.8 WAND (2002, JFM)

WAND (2002) showed that the binomial option pricing errors

are related to the node positioning and they defined a ratio for
node positioning.
 3.8 WAND (2002, JFM)

The relationship between the errors and node positioning.

 3.9 GCRR model
Theorem 1. In the GCRR model, the three parameters are as
follows:
u  e t
,
1
  t
d e 
,
e r t  d
p ,
ud
where   R is a stretch parameter which determines the shape of
the binomial tree. Moreover, when t  0, i.e., the number of time
steps n grows to infinity, the GCRR binomial prices will converge
to the Black-Scholes formulae for European options.
• Obviously the CRR model is a special case of our GCRR model
when .  1
• We can easily allocate the strike price at one of the final nodes.
 3.9 GCRR model
Various Types of GCRR models:
 4. Binomial models for exotic
options
Topics:
1. Path dependent options using trees
• Lookback options
• Barrier options
2. Options where there are two stochastic
variables (exchange option, maximum
option, etc.)
 Path Dependence:
The Traditional View

• Backwards induction works well for

American options. It cannot be used for
path-dependent options
• Monte Carlo simulation works well for
path-dependent options; it cannot be
used for American options
 Extension of Backwards
Induction
• Backwards induction can be used for some
path-dependent options
• We will first illustrate the methodology using
lookback options and then show how it can
be used for Asian options
 Lookback Example (Page 462)
• Consider an American lookback put on a stock where
S = 50,  = 40%, r = 10%, t = 1 month & the life of
the option is 3 months
• Payoff is Smax-ST
• We can value the deal by considering all possible
values of the maximum stock price at each node
(This example is presented to illustrate the methodology. A more efficient
ways of handling American lookbacks is in Section 20.6.)
 Example: An American Lookback Put
Option (Figure 20.2, page 463)
S0 = 50,  = 40%, r = 10%, t = 1 month, 70.70
70.70
62.99 0.00

62.99 56.12
56.12
3.36 62.99 56.12
56.12 50.00 6.87 0.00
50.00
4.68 A
5.47
56.12 50.00 44.55
44.55
6.12 2.66 56.12 50.00
50.00 11.57 5.45
36.69
6.38
50.00 35.36
10.31 50.00
14.64
 Why the Approach Works
This approach works for lookback options because
• The payoff depends on just 1 function of the path followed
by the stock price. (We will refer to this as a “path
function”)
• The value of the path function at a node can be calculated
from the stock price at the node & from the value of the
function at the immediately preceding node
• The number of different values of the path function at a
node does not grow too fast as we increase the number of
time steps on the tree
 Extensions of the
Approach
• The approach can be extended so that there
are no limits on the number of alternative
values of the path function at a node
• The basic idea is that it is not necessary to
consider every possible value of the path
function
• It is sufficient to consider a relatively small
number of representative values of the function
at each node
 Working Forward
• First work forwards through the tree
calculating the max and min values of
the “path function” at each node
• Next choose representative values of
the path function that span the range
between the min and the max
– Simplest approach: choose the min, the
max, and N equally spaced values
between the min and max
 Backwards Induction

• We work backwards through the tree in the

usual way carrying out calculations for each of
the alternative values of the path function that
are considered at a node
• When we require the value of the derivative at
a node for a value of the path function that is
not explicitly considered at that node, we use
linear or quadratic interpolation
 Part of Tree to Calculate
Value of an Option on the S = 54.68
Arithmetic Average Y Average S Option Price
47.99 7.575
51.12 8.101
54.26 8.635
0.5056
57.39 9.178

S = 50.00
Average S Option Price
46.65 5.642 X
49.04 5.923
51.44 6.206 S = 45.72
53.83 6.492
Average S Option Price
0.4944 43.88 3.430
46.75 3.750
49.61 4.079
52.48 4.416
S=50, X=50, =40%, r=10%, T=1yr, Z
t=0.05yr. We are at time 4t
Part of Tree to Calculate Value of
an Option on the Arithmetic
Average (continued)
Consider Node X when the average of 5
observations is 51.44
Node Y: If this is reached, the average becomes
51.98. The option price is interpolated as 8.247
Node Z: If this is reached, the average becomes
50.49. The option price is interpolated as 4.182
Node X: value is
(0.5056×8.247 + 0.4944×4.182)e–0.1×0.05 = 6.206
A More Efficient Approach for
Lookbacks (Section 20.6, page 465)
F (t )
 Define Y (t ) 
S (t )
where F ( t ) is the MAX stock price
 Construct a tree for Y (t )
 Use the tree to value the lookback
option in " stock price units" rather
than dollars
 Using Trees with Barriers
(Section 20.7, page 467)

• When trees are used to value

options with barriers,
convergence tends to be slow
• The slow convergence arises
from the fact that the barrier is
inaccurately specified by the tree
 True Barrier vs Tree Barrier for a
Knockout Option: The Binomial Tree Case
Barrier assumed by tree
True barrier
 True Barrier vs Tree Barrier for a Knockout
Option: The Trinomial Tree Case
Barrier assumed by tree
True barrier
Bumping Up Against the Barrier with the
Binomial Method,
JD, Boyle and Lau (1994)
 m 2 2T
F  m  2
, m  1, 2,3,
 S 
 log 
 H
m F(m)
1 21.38
2 85.52
3 192.42
4 342.08
5 534.51
On Pricing Barrier Options,
JD, Ritchken (1995)
   t with probability Pu

  t  
a
0 with probability Pm

 t with probability Pd
where   1 and Pu , Pm , and Pd are
1  t
Pu  2 
2 2
1
Pm  1  2

1  t
Pd  2 
2 2
Complex Barrier
Options
Cheuk and Vorst (1996)

•Time varying barrier

•Double barriers
u *  i   u  i   e
 t  log  i 

d *  i   d  i   e   t  log  i 

m*  i   m  i   e
log  i 
 Alternative Solutions
to the Problem
• Ensure that nodes always lie on the
barriers
• Adjust for the fact that nodes do not
lie on the barriers
• Use adaptive mesh

In all cases a trinomial tree is

preferable to a binomial tree
 Multi-Asset Case
Reference:
• Boyle, P. P., J. Evnine, and S. Gibbs, 1989, Numerical Evaluation of Multivariate
Contingent Claims, The Review of Financial Studies, 2, 241-250.
• Chen, R. R., S. L. Chung, and T. T. Yang, 2002, Option Pricing in a Multi-Asset,
Complete Market Economy, Journal of Financial and Quantitative Analysis, 37, 649-
666.
•   Ho, T. S., R. C. Stapleton, and M. G. Subrahmanyam, 1995, Multivariate Binomial
Approximations for Asset Prices with Nonstationary Variance and Covariance
Characteristics, The Review of Financial Studies, 8, 1125-1152.
•  Kamrad, B., and P. Ritchken, 1991, Multinomial Approximating Models for Options
with k State Variables, Management Science, 37, 1640-1652.
•  Madan, D. B., F. Milne, and H. Shefrin, 1989, The Multinomial Option Pricing Model
and Its Brownian and Poisson Limits, The Review of Financial Studies, 2, 251-265.
 Modeling Two Correlated Variables
Consider a two-asset case:
dS1t
 (r  q1 )dt   dZ1t ,
S1t
dS 2t
 (r  q2 )dt   dZ 2t ,
S 2t
cov(dZ1t , dZ 2t )   dt.

Under the first approach: Transform variables so that they are not
correlated & build the tree in the transformed variables

d ln S1t   r  q1   12 / 2  dt 1dZ1t

d ln S2t   r  q2   22 / 2  dt 2 dZ 2t
 Modeling Two Correlated Variables
We define two new uncorrelated variables:
x1   2 ln S1   1ln S2
x2   2 ln S1   1ln S 2
These variables follow the processes:
dx1   2  r  q1   12 / 2    1  r  q2   22 / 2   dt  1 2   dz A

dx1   2  r  q1   12 / 2    1  r  q2   22 / 2   dt  1 2   dzB

where dz A and dzB are uncorrelated Wiener processes.

At each node of the tree, S1 and S2 can be calculated from x1 and x2
using the inverse relationships

x  x   x1  x2 
S1  exp  1 2  S 2  exp  
 2 2   2  1 
 Modeling Two Correlated Variables
Take the correlation into account by adjusting the
position of the nodes:

1
( r  q1  12 ) t 1 tZ1
S1t t  S1t e 2

1
( r  q2   2 2 ) t   2 tZ1  1  2  2 tZ 2
S2t t  S2t e 2

 1  1
 1, p  1, p
 2  2 , Z and Z are independent
Z1   Z2   1 2
1, 1 1, 1
p p

 2 
 2
 Modeling Two Correlated Variables
Take the correlation into account by adjusting the probabilities
1
( r  q1  12 ) t 1 tZ1
S1t t  S1t e 2

1
( r  q2   2 2 ) t  2 tZ 2
S2t t  S 2t e 2

   1 2 1 2 
 1  r  q1  2  1 r  q2  2  2  
(1,1) p  1    t   
 4   1 2 
    

   1 1 
  r  q1   12 r  q2   2 2  
1
(1, 1) p  1    t 2 2
    
4  1 2 
 
   
( Z1 , Z 2 )  
   1 1 
  r  q1   12 r  q2   2 2  
 1 2 2
(1,1) p  4 1    t   1

2

   
    
   1 2 1 2 

1   r  q1  2  1 r  q2  2  2  
(1, 1) p  1    t    
 4   1 2 
    
 Multi-Asset tree model under complete
market economy
Chen, R. R., S. L. Chung, and T. T. Yang, 2002, Option Pricing in a
Multi-Asset, Complete-Market Economy, Journal of Financial and
Quantitative Analysis, Vol. 37, No. 4, 649-666.
With two uncorrelated Brownian motions with equal variances, the
three points, A, B, and C, are best to be “equally” apart from each
other. This can be achieved most easily by choosing 3 points,
located 120 degrees from each other, on the circumference of a
circle, as shown in Exhibit 2.
y axis

C’

A’
x axis

C B

B’
 Multi-Asset tree model under complete
market economy
To incorporate the correlation between the two Brownian motions, we then
rotate the axes, as shown in Exhibit 3.

y axis
y axis (rotated)

A A*
x axis (rotated)



x axis
B*

C B

C*
 Multi-Asset tree model under complete
market economy
Proposition 2
The rotation of the axes is defined as follows:

 1 tan    *
 xˆ j   1 tan 2  1 tan 2    x j 
  tan    *
 yˆ j   1
  y j 
 1 tan 2  1 tan 2 

 2 X*2

where  is the rotation angle of the x-axis counterclockwise and y-axis

clockwise. After rotation, we have:
•the means and the variances of the rotated ellipse remain unchanged
and
•the correlation is a function of the rotation degree :

sin 1 

2
 Multi-Asset tree model under complete
market economy
Finally, for any given time, t, the next period stock prices are:

 ln S1,1,t  t ln S 2,1,t  t 
 
ln S1,2,t  t ln S 2, 2,t  t 
 ln S1,3,t  t ln S 2,3,t  t 

1  rx xˆ1 ry yˆ1 
 
 1  ln S1,t  (r  21 )t ln S 2,t  (r  22 )t   rx xˆ 2
 2
 2

ry yˆ 2 
 
1  rx xˆ 3 ry yˆ 3 

5. Binomial models for
other processes
Time-varying volatility
processes
 how to construct a recombined
binomial/trinomial tree under time-
varying volatility?
1. Amin (1991) suggested changing the number of steps
(or dt) such that the tree is recombined.
2. Ho, Stapleton, and Subrahmanyam (1995) suggested
using two steps to match the conditional and
unconditional volatility and unconditional mean.
3. Using the trinomial tree of Boyle (1988) or Ritchken
(1995). See next page.
Ref : Amin (1995, pp.39-40) has a very nice discussion on
this issue.
Amin, 1995, Option Pricing Trees, Journal of Derivatives,
34-46.
 Amin (1991)(1/2)

Assume that the underlying asset price follows

dS = rSdt + (t)Sdz
then the annual variance of the asset price over the period
[0, T] is T
 2  t  dt
V 
0 T
T
Let N be the number of time steps desired, then t  N
.
The time step for each period is denoted as h(t), h(2t),
…, h(nt). Amin let

 2  t  h t    2  2t  h 2t      2  nt 

h nt   Vt
 Amin (1991)(2/2)

In this case, the tree is recombining because

u  t   e    t  h t
 u  2t     u  nt 
where u(t), u(2t), …, u(nt) are size of up movement at
each period.
Following Boyle (1988), the asset price, at any given time,
can move into three possible states, up, down, or middle, in
the next period. If S denotes the asset price at time t, then at
time t + dt, the prices will be Su, Sd, or Sm. The parameters
are defined as follows
u  e  dt
d  e  dt

and m 1

where   1, the dispersion parameter, is chosen freely as

long as the resulting probabilities are positive. Let i
represent the instantaneous volatility at time ti, then we can
set  j j dt
i i dt
e e  i, j
In this case the tree is recombining and the probability of
each branch is of course time varying.
To guarantee that the resulting probabilities are positive, we
must carefully choose dt and . Roughly speaking, dt must
be small enough such that

dt 
(r  0.5   2 )

For , as discussed in Boyle (1988), its values must be larger

than 1. Denote the maximum and minimum of the
instantaneous volatility for the period from time 0 to T as
max and min. Then
max max dt min min dt
e e
We can arbitrarily set max as 1.1 and then all other i will be
larger than 1 automatically.
 
Ref :
Boyle, P. (1988), A Lattice Framework for Option Pricing with
Two State Variables, Journal of Financial and Quantitative
Analysis, 23, 1-12.
 Stochastic volatility
stochastic interest rate
processes
Reference:
1. Hilliard, J. E., and A. Schwartz, Pricing Options on Traded
Assets under Stochastic Interest Rates and Volatility: A Binomial
Approach, Journal of Financial Engineering, 6, 281-305.
 2. Hilliard, J. E., A. L. Schwartz, and A. L. Tucker, 1996, Bivariate
Binomial Options Pricing with Generalized Interest Rate
Processes, Journal of Financial Research, 14, 585-602.
3. Nelson, D. B., and K. Ramaswamy, 1990, Simple Binomial
Processes as Diffusion Approximations in Financial Models,
Review of Financial Studies, 3, 393-430.
4. Ritchken, P., and R. Trevor, 1999, Pricing Option under
Generalized GARCH and Stochastic Volatility Processes, Journal
of Finance, 54, 377-402.
5. Hillard, J. E., and A. Schwartz, 2005, “Pricing European and
American Derivatives under a Jump-Diffusion Process: A Bivariate
Tree Approach,” Journal of Financial and Quantitative Analysis,
40, 671-691.
6. Camara, A., and S. L. Chung, 2006, Option Pricing for the
Transformed-Binomial Class, Journal of Futures Markets, Vol. 26,
No. 8, 759-788.
 Nelson and Ramaswamy (1990)

Nelson and Ramaswamy (1990) proposed a general tree

method to approximate diffusion processes.

Generally a binomial or trinomial tree is not recombined

because the volatility is not a constant. Nelson and
Ramaswamy (1990) suggested a transformation of the
variable such that the transformed variable has a constant
volatility.
Nelson and Ramaswamy (1990)
Nelson and Ramaswamy (1990)
For example, under the CEV model:
Nelson and Ramaswamy (1990)
For example, under the CIR model:
 Hilliard-Schwartz: Stochastic
Volatility
The asset price and return volatility are assumed to follow:
dS = msdt + f(S)h(V)dZs
dV = mvdt + bVdZv (1)
Under Q measure ms ＝ S(r - d).
First of all, make the following transformation to obtain a
unit variance variable Y:

ln V 
Y 
b
 mv 
dY    0.5b dt  dZ v
 bV 
Next, make the following transformation to obtain a
constant variance variable H:
dH  H S V S  dZ S  H V bVdZV  mh dt
 mh dt   h dZ h (4)
where
mh  H s ms  H v mv  0.5H ss S 2V  0.5H v v b 2V 2  H sv bVS V  sv


 h  1  bH SV  0.25 bH 
2
 0.5
Then make another transformation to obtain a unit variance
variable Q.

dQ  mq dt  dZ h
(5)
where
mh
mq   0.5Qhh h2
h
 Binomial tree for Y and trinomial tree for Q

Y2, 2
Y1, 1
Y0, 0 Y2, 0

Y1, -1
Y2, -2
Q2, 2
Q1, 1 Q2, 1
Q0, 0 Q1, 0 Q2, 0

Q1, -1 Q2, -1
Q2, -2

T/n = h : 0 1 2
 Option Pricing under GARCH

Ritchken, P., and R. Trevor, 1999, Pricing Option under Generalized

GARCH and Stochastic Volatility Processes, Journal of Finance, 54,
377-402.
GARCH model:

The main idea is to keep the spanning of the tree flexible, i.e. the size of
up or down movements can be adjusted to match the conditional
variance.
 Option Pricing for the
Transformed-Binomial Class

AntÓnio Câmara1 and San-Lin Chung2

January 2004

11 School
SchoolofofManagement,
Management,University
UniversityofofMichigan-Flint,
Michigan-Flint,3118
3118William
WilliamS.
S.White
White
Building, Flint, MI 48502-1950. Tel: (810) 762-3268, Fax: (810) 762-3282,
Building, Flint, MI 48502-1950. Tel: (810) 762-3268, Fax: (810) 762-3282,
Email:
Email:acamara@umflint.edu
acamara@umflint.edu
22 Department
DepartmentofofFinance,
Finance,The
TheManagement
ManagementSchool,
School,National
NationalTaiwan
Taiwan
University, Taipei 106, Taiwan. Tel:886-2-23676909, Fax:886-2-23660764,
University, Taipei 106, Taiwan. Tel:886-2-23676909, Fax:886-2-23660764,
Email:
Email:chungs@mba.ntu.edu.tw.
chungs@mba.ntu.edu.tw.
 Abstract
This paper generalizes the seminal Cox-Ross-
Rubinstein (1979) binomial option pricing model
(OPM) to all members of the class of transformed-
binomial pricing processes. Our investigation
addresses issues related with asset pricing
modeling, hedging strategies, and option pricing.
We derive explicit formulae for (1) replicating or
hedging portfolios; (2) risk-neutral transformed-
binomial probabilities; (3) limiting transformed-
normal distributions; and (4) the value of contingent
claims. We also study the properties of the
transformed-binomial class of asset pricing
rocesses. We illustrate the results of the paper with
several examples.
 I. Introduction (1/7)
multiplicative-binomial option pricing
model: Cox, Ross, and Rubinstein (1979),
Rendlemen and Bartter (1979), and Sharpe
(1978)

pricing by arbitrage: According to this rule,

when there are no arbitrage opportunities, if
a portfolio of stocks and bonds replicates the
payoffs of an option then the option must
have the same current price as its replicating
portfolio.
 I. Introduction (6/7)
Third, this paper provides a class of distributions that
may explain observed option prices (or implied
volatilities).
 Multiplicative-binomial (hereafter, M-binomial) model:

This M-binomial model assumes that u = 2 and d = 0.5.

 The SL-binomial model with a lower bound  at
maturity:

For example, if r = 1.25 and  = 10 then this SL-binomial

model assumes that u = 2.1429 and d = 0.3571.
 The following SU-binomial model:

In this SU-binomial model, it is assumed that u =

1.4107 and d = 0.7106.
 The following SB-binomial model with a threshold :

For example, if  = 300 then this SB-binomial model

assumes that u = 2.5 and d = 0.4545.
 The SL-binomial model

Following Johnson (1949), the transformation for the

SL-binomial is defined as the following in this article:

  
g S i ,k   ln S i , k    r
  t  i t 

 The SU-binomial model

The transformation for the SU-binomial model is

defined as:
 
g S i , k   sinh 1  
S i ,k   ln  S i , k   1  S i ,k  
 The SB-binomial model

The third example considered in this paper is the SB-

binomial model, corresponding to the SB-normal model
of Johnson (1949). The transformation for the SB-
binomial model is as follows:

 S i , k  

g S i , k    ln 
   S i , k 


 
 Figure 1: The convergence of the S_L binomial price to its closed form
solution

13.6

13.55
S_L binomial
13.5 price
closed-form
price

13.45

13.4

13.35

13.3
20 40 60 80 100 120 140 160 180 200
number of time steps

This figure shows the convergence pattern resulting from option price
calculations with the SL-binomial model. We use the following selection of
parameters: S = 100, K = 100, r = 0.1,  = 20, t = 1.0,  = 0.25.
 Figure 2: The convergence of the S_U binomial price to its closed form
solution

24.3
24.25
24.2
24.15 S_U binomial
24.1
price
24.05 closed-form
price

24
23.95
23.9
23.85
23.8
23.75
20 40 60 80 100 120 140 160 180 200
number of time steps

This figure shows the convergence pattern resulting from option price
calculations with the SU-binomial model. We use the following selection of
parameters: S = 100, K = 100, r = 0.1, t = 1.0,  = 0.25.
 Figure 3: The convergence of the S_B binomial price

12.24

12.22

12.2

12.18 S_B binomial

price
price

12.16

12.14

12.12

12.1

12.08
20 40 60 80 100 120 140 160 180 200
number of time steps

This figure shows the convergence pattern resulting from

option price calculations with the SB-binomial model. We
use the following selection of parameters: S = 100, K =100, r = 0.1,  =
300, t = 1.0,  = 0.25.