Document Date: November 2, 2006
An Introduction To Derivatives And Risk Management
, 7
th
EditionDon Chance and Robert BrooksTechnical Note: Call Price Derivation Based on Hedged Portfolio, Ch. 4, p. 95
This technical note supports the material in the One-Period Binomial Modelsection of Chapter 4 Option Pricing Models: The Binomial Model. The objective here isto provide more details on the derivation of the one-period binomial option pricingmodel.
Hedged Portfolio
From the text, we can create a hedged portfolio that results in
( )( )
u
ChuSr 1ChS
−=+−
where
dSuSCCh
du
−−=
.The left-hand side is the future value of the investment in h shares of stock and writingone call. The right hand side is the value at expiration of this hedge portfolio. Becausethe portfolio is risk-free, then the future value of the investment should equal the risk-free payout. Substituting for h and solving for C, we have
( )
ududu
CuSdSuSCCr 1CS
dSuSCC
−−−=+ −−−
.The first step in making sense of this is to cancel S,
( )
ududu
CuduCCr 1CduCC
−−−=+ −−−
. Now we will divide by (1 + r) and rearrange to isolate the initial call price,
( )
−−−+−−−=
ududu
CuduCCr 11duCCC
.We know the final result will be terms that depend on r, u and d. Therefore, factoring outthe present value term, multiplying and dividing by u – d, and rearranging,
( )( )( )
−−−−−−−+−+=
ududu
CduduuduCCdur 1CC
r 11C
.Establishing a common denominator and rearranging once again,
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