TN3 Derivation of Up Probability Converging to 50 Percent

Document Date: November 2, 2006

An Introduction To Derivatives And Risk Management

, 7

th

EditionDon Chance and Robert BrooksTechnical Note: Derivation of Up Probability Converging to 50 Percent, Ch. 4, p. 117

This technical note supports the material in the Alternative Specifications of theBinomial Model section of Chapter 4 Option Pricing Models: The Binomial Model.Caution, this technical note is somewhat mathematically advanced. The objective here isto provide more details on the alternative specification and to demonstrate that under thisalternative specification, the probability of an up jump converges to ½ as the time stepgets smaller. This convergence is a useful property for some applications, particularlyinterest rate options which are covered later in the book.

Binomial Probability Specifications

Note that the per period interest rate is computed as:

( )

1r 1r

nTa

−+=

where denotes the annual compounded risk-free interest rate, T denotes the fraction of the year until the option matures, and n denotes the number of binomial steps. We willapply continuously compounded interest rates, hence,

a

r

( )

   

=+=+

nTr nTa

c

er 1r 1

.Based on the properties of exponentials and natural logs, we have

( )( )

        ++

==

nTr nTr 1lnr 1ln

ca

eee

.The

traditional specification

of the binomial model for stock options given in thischapter is:

nT

eu

σ

=

nT

eu1d

σ−

==

( )

nTnT nTr 1ln

eeeedudr 1 p

σ−σσ−+

−−=−−+=

.An

alternative specification

also given in this chapter is:

( )

nTnT2r 1ln

2a

eu

σ+    σ−+

=

( )

nTnT2r 1ln

2a

ed

σ−    σ−+

=

( )( )( ) ( )

nTnT nT2nTnTnT2r 1lnnT nT2r 1lnnTnT2r 1lnnTr 1ln

eeeeeeeedudr 1 p

22a2a2aa

σ−σσ−    σσ−    σ−+σ+     σ−+σ−    σ−+    +

−−=−−=−−+=

Lognormal Distribution

We briefly review the lognormal distribution with a focus on its application toasset prices. Almost any intermediate or advanced statistics book will offer more details.For more advanced materials, see Stuart and Orr (1988) or Aitchison and Brown (1957).First, we define the lognormal distribution for some generic variable,

x~

, whererandomness is depicted with the tilde (~) on the top. The tilde beside the random variableis read as “is distributed.” Assume

x~

is distributed as a normal distribution, that is,, where denotes the normal distribution,

(

σµ

, N~x ~

) )(

••

, N

µ

is the mean, and is thestandard deviation. If , then

σ

{ }

x~expy~

=

( )

σµΛ

,~y~

, where

( )

••Λ

,

denotes the lognormaldistribution.In the context of rates of return on stocks, suppose

{ }

TR ~expSS~

tT

=

.If

(

σµ

, N~R

)

~

, then

( )

(

T,TSln~S ~

0T

σµ+Λ

.From the properties of the lognormal distribution we have the expected terminal valueand variance of the asset price expressed as,

[ ]

    σ+µ=

T2expSS~E

20T

( ){ } ( ){ }

[ ]

T2expT2expSS ~Var

222T

0

σ+µ−σ+µ=

.Alternatively, the normal distribution parameters can be expressed as a function of thelognormal distribution parameters.

[ ]

TSS~Eln

0t

=µ

2

[ ][ ]

{ }

T1S~ES~var ln

2tt2

+=σ

.

Binomial Convergence Theorems

From the material in this chapter, we know that option prices are based on the present value of the expected terminal option price, where the underlying asset isassumed to grow at the risk-free interest rate. That is,

{ }

Tr expSS ~E

c0T

=

.From the previous section, we know one property of the lognormal distribution is,

[ ]

    σ+µ=

T2expSS~E

20T

.Setting these two expectations equal and solving for the mean, we have

2r

2c

σ−=µ

.We now turn to the

general specification

of the binomial process. Assuming the probability of an up jump, p, must be positive and less than one, if

( )

nTnTm ˆ

eu

σ+

=

( )

nTnTm ˆ

ed

σ−

=

σ−    σ−+=

nTmˆ2r 121 p

2c

where

nT

denotes a discrete change in time,

mˆ

is a free parameter sometimes referredto as the revealed preference parameter, u and d are the multiplicative parameters used tocompute future values of S (), where n denotes periods in the future and jdenotes the number of times up occurs). Then as

0 jn j j,n

SduS

−

=∞→

n

(interpret, getting larger) or

3

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