Financial Derivatives Section 5

The Binomial Model of Option Pricing

Michail Anthropelos anthropel@webmail.unipi.gr http://web.xrh.unipi.gr/faculty/anthropelos/ University of Piraeus

Spring 2011

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

1 / 38

Outline

One Period Binomial Model Introduction Pricing European options

Two Periods Binomial Model Pricing of European options Pricing of American Options The Eect of Dividend

Construction of a Binomial Tree

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

2 / 38

Outline

One Period Binomial Model Introduction Pricing European options

Two Periods Binomial Model Pricing of European options Pricing of American Options The Eect of Dividend

Construction of a Binomial Tree

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

3 / 38

Option Pricing

What have we seen so far?

Payos and P/L functions of options. Factors that aect the option prices. Arbitrage-bounds of option prices (with and without dividend).

The next step...

Is there a way to give a price to an option using only non-arbitrage arguments as we have done with futures and swaps? Ans: Well...lets see.

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

4 / 38

The Binomial Model

What is it?
The binomial model is a simplied, discrete time model -developed by Cox, Ross & Rubinstein in 1979- which: values the prices of European and American options, is exible enough to include dividends. works as a rst step to more complicated market models.

Although very simple...

The binomial model: incorporates the essential principles of option pricing, i.e.,
1 2

Pricing by replication. Risk-neutral valuation.

describes in a clear way the eects of all the aecting factors. can be used for pricing more complicated derivatives.

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

5 / 38

The Stock and the Call

The price of the stock at time t = 0 is S(0). Suppose that at time t = T there are two possible cases for the stock price:

where, d < 1 + r < u. The situation of a call option written on this stock is the following:

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

6 / 38

Replication Portfolio
The main idea
The main idea is to construct a portfolio which consists of stocks and a cash amount B invested in the free-risk interest rate such that: Portfolio payo = Call option payo Assuming NON-ARBITRAGE, the price of the call should be equal to cost of the portfolio at time t = 0.

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

7 / 38

Replication Portfolio contd

We have to choose and B such that: uS(0) + B(1 + r ) dS(0) + B(1 + r ) = cu = cd

If we suppose that, uS(0) > K and dS(0) < K , we have to solve: uS(0) + B(1 + r ) dS(0) + B(1 + r ) (two equations and two unknowns). = uS(0) K = 0

Perfect replication
By doing so, we perfectly replicate the call option payo.

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

8 / 38

The Price of European Call Option

We easily get the following solutions for and B: =
cu cd S(0)(ud)

B=

ucd dcu (ud)(1+r )

The replication portfolio

The replicating portfolio: Buy stocks. Lend/borrow the amount
ucd dcu (ud)(1+r ) .

The payo of this portfolio is identical to the call option payo.

Price of call = Cost of the Portfolio

Under the non-arbitrage assumption, the cost of the replicating portfolio, S(0) + B, should be equal to the call price: c=
1 1+r cu ((1+r )d) ud

cd (u(1+r )) ud

Hedging ALL the Risk on Option Positions

Seller side
The strategy of the option seller is the following: At time t = 0: Sell the option and receive c. Buy stocks. Borrow/lend B in cash. At time t = T : Use the amount S(T ) + B(1 + r ) to give the payo max{S(T ) K , 0}. He starts with zero and ends up with zero (no risk exposure).

Buyer side
Similarly, the strategy of the option buyer is the following: At time t = 0: Short stocks. Borrow/lend B in cash. Buy the option by giving c. At time t = T : Get the payo max{S(T ) K , 0} and use it to return S(T ) and close the interest free investment. He starts with zero and ends up with zero(no risk exposure).

Interpretation of Option Price

By shorting an option at price c and following the replication portfolio, there is no risk exposure. The subjective probabilities of upward and downward stock movements do not aect the option price. The investors preference and predictions do not aect the option price. c is the unique non-arbitrage price. If the price of an option is dierent than that the non-arbitrage price, one can make an arbitrage by following the corresponding replication strategy. It is clear how each aecting factor inuences the option price. This method can be used for pricing any kind of derivatives written on this stock.

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

11 / 38

Risk-Neutral Valuation
The option price can be written as: c= Note that
(1+r )d ud

1 cu 1+r , c=

(1 + r ) d ud > 0 and

+ cd
(1+r )d ud

u (1 + r ) ud +
u(1+r ) ud

. = 1. Hence,

u(1+r ) ud 1 1+r [qcu

+ (1 q)cd ] =

1 1+r Eq

[C (T )]

In other words, we may consider the option price as the discounted expectation of the option payo, where the probability of the upward movement of the stock price is given by q = 1+r d and ud the probability of the downward movement is given by 1 q =
u1r ud

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

12 / 38

Risk-Neutral Valuation contd

Interpretation of the probability q
If the probability of stock price upward movement is q and the probability of the stock price downward movement is 1 q, what is the expected return of the stock price? Eq [S(T )] = quS(0) + (1 q)dS(0) = (1+r )d uS(0) + u(1+r ) dS(0) = ud ud = S(0)(1 + r ). This means that under the probabilities (q, 1 q) the expected return of the stock price is equal to the risk-free interest rate. The probability measure (q, 1 q) is called risk-neutral.

Why is that?
The reason for which the price of the option is equal to the discounted expectation of the option payo under the risk-neutral probability is that the investment on option is risk-free and hence it should have the same expected return as the risk-free investment.

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

13 / 38

Non-Arbitrage and Risk-Neutral Pricing

Synopsis
If the perfect replication of an option payo is possible, there is no risk involved in the option positions, as long as the option price is the unique non-arbitrage price. No risk exposure means that the expected return of the option is equal to risk-free interest rate. By setting the probabilities of upward and downward movement equal to q and 1 q respectively, we assume that the world is risk-neutral in which:
individuals are indierent to risk. the expected return on all securities is the risk-free interest rate.

There is in fact an equivalence between the non-arbitrage pricing and the risk-neutral valuation.

Important notice
If the perfect replication is possible, the risk-neutral valuation holds not only in the risk-neutral world but also in the real one.

One Period Binomial Model, an example

Suppose that the Microsoft stock price is $28 today. After one year there are two possible outcomes:

A call option written on the Microsoft stock price, with strike price $28 and maturity after one year is described below:

One Period Binomial Model, an example

Assume also that r = 5% (annual compounding). The parameters of the replication portfolio are = and B= 2.8 cu cd = = 0.5 S(0)(u d) 28(1.1 0.9)

0.9 2.8 ucd dcu = = $12. (u d)(1 + r ) (1.1 0.9)1.05

Hence, the replication strategy is the following: Borrow $12 at the risk-free rate and buy 0.5 stocks at the price $28. The cost of this portfolio is 14 12 = $2. This means that c = $2. The risk-neutral probabilities are q = (1+r )d = 1.050.9 = 0.75 and 1 q = 0.25. ud 1.10.9 Hence, the call option price can also be given by: c= 1 1 (qcu + (1 q)cd ) = 0.75 2.8 + 0 = $2. 1.05 1.05

Outline

One Period Binomial Model Introduction Pricing European options

Two Periods Binomial Model Pricing of European options Pricing of American Options The Eect of Dividend

Construction of a Binomial Tree

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

17 / 38

The Two Period Binomial Model

We take one step ahead and we impose two time periods. At each time, we assume that the stock price increases at the rate of u or decreases at d.

Similarly, for a call option written on this stock:

Backward Induction
In order the nd the value of the call option at each node of the binomial tree, we work backwards. First focus on two branches on the upper right:

At the node of Su , replication portfolio equations for and B are: S(0)u 2 + (1 + r )B S(0)ud + (1 + r )B = cuu = cud

ucud dcuu cuu cud whose solutions are = uS(0)(ud) and B = (ud)(1+r ) . (note the similarity with the one period case).

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

19 / 38

Backward Induction contd

The cost of this portfolio at time t = 1, which equals to cu is: uS(0) + B = 1 cuu 1+r (1 + r ) d ud + cud u (1 + r ) ud .

The risk-neutral probabilities

As in the one period case, the value of the call option at the node of Su can be given as the discounted (at time t = 1) expected payo of call option, under the risk-neutral probability q = (1+r )d , i.e., ud cu = 1 Eq [c(2) | S(1) = Su ] . 1+r

At the same way, we calculate that:

cd = 1 1 Eq [c(2) | S(1) = Sd ] = cud 1+r 1+r (1 + r ) d ud + cdd u (1 + r ) ud .

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

20 / 38

The Price of the Option at Time t = 0

After calculating the option value at time t = 1, we can follow exactly the same method in order to value the option at time t = 0. We encounter the following part of the binomial tree:

We get:
c = = = = 1 1 Eq [c(1)] = [qcu + (1 q)cd ] = (1 + r ) (1 + r ) 1 [q(qcuu + (1 q)cud ) + (1 q)(qcud + (1 q)cdd )] = (1 + r )2 1 q 2 cuu + 2q(1 q)cud + (1 q)2 cdd = (1 + r )2 1 Eq [c(2)]. (1 + r )2

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

21 / 38

Two Period Binomial Model, an example

The possible cases for the Microsoft stock prices are described in the following tree:

The situation of a call option with strike price $28 is the following:

Two Period Binomial Model, an example

The risk-neutral probability of upward movement: q = 1.050.9 = 0.75 1.10.9 The option price at time t = 1 1 cu = 1.05 (0.75 5.88) = $4.2 and d = 0 c The option price at time t = 0 1 c = 1.05 (0.75 4.2) = 5.88) = $3

1 2 1.052 (0.75

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

23 / 38

The Delta Hedging

For the perfect replication of the call option payo, we should calculate the number of the stocks that has to be purchased at each node of the binomial tree. This is the Delta hedging strategy: At time t = 1 5.88 u = 30.80.2 = 0.95 and d = 0 And at time t = 0 = = 0.75

4.2 280.2

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

24 / 38

The Case of American Options

The idea
For the price of the American option, we have to take into account the right of the option buyer to exercise the option at each node of the binomial tree. Simply, at each node the price of an American option is the maximum between the price of a corresponding European option and the intrinsic option value. In other words, for each note t, we have: Ct = max{ct , S(t) K } and Pt = max{pt , K S(t)}

The early exercise

The early exercise of an American option is optimal if the intrinsic value of the option is larger than the price of the corresponding European option.

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

25 / 38

The Case of American Options, an example

Consider again our Microsoft example:

The value of the European put option on this stock with strike $28 is described below:

The Case of American Options, an example

Note that the risk-neutral probability of upward movement remains the same (it depends on the stock price and the interest rate, but not on the option payo ): q = 1.050.9 = 0.75 1.10.9 The option price at time t = 1 1 pu = 1.05 (0.75 0 + 0.25 0.28) = $0.067 and 1 pd = 1.05 (0.75 0.28 + 0.25 5.32) = $1.467 The option price at time t = 0
p=
1 (0.75 1.05

0.067 + 0.25 1.467) =

1 (2 1.052

0.75 0.25 0.28 + 0.252 5.32) = $0.4

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

27 / 38

The Case of American Options, an example

For the determination of the American put option price at time t = 1, we compare the two following trees: The tree of the European put option values:

And the tree of the intrinsic option values:

The Case of American Options, an example

Therefore the price of the American put option at each node of the tree is given below:

At time t = 0, we compare the intrinsic value (=0 in this example) and the value Eq [P(1)] = q 0.067 + (1 q) 2.8 = 0.75025.

The early exercise

At the node Sd , it is optimal for the option holder to exercise the put option and get the payo of $2.8.
M. Anthropelos (Un. of Piraeus) Binomial Model Spring 2011 29 / 38

How Dividend Enters the Tree

As we have seen, on the ex-dividend day, the stock price drops by the dividend amount. This decline occurs in two ways: The dividend is given as a cash amount. The dividend is given through a continuous dividend yield.

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

30 / 38

How Dividend Enters the Tree contd

In the case there is a dividend D given at time t = 1, we have:

If the dividend is given at t = 1 through a continuous dividend yield a, the tree becomes:

Outline

One Period Binomial Model Introduction Pricing European options

Two Periods Binomial Model Pricing of European options Pricing of American Options The Eect of Dividend

Construction of a Binomial Tree

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

32 / 38

Starting the Construction of a Tree

How to construct a tree
When we start the construction of a binomial tree, we have to specify the following parameters:
1 2

The upward and the downward movement, i.e. u and d. The number of the time intervals (periods) which divide the time to maturity.
The more time intervals, the more accuracy we get.

The parameters u and d

The parameters u and d match the stock price volatility. It is recalled that the volatility, , is given by: Var (Stock return for time period t) = 2 t.

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

33 / 38

u, d and
Let and be the expected (continuous) return and the volatility of the stock return, respectively. E[S(t)] = S(0)e t . If p and 1 p are the subjective probabilities of the upward and the downward movement of the stock price, we have: pS(0)u + (1 p)S(0)d = S(0)e t p = Since, Var (Stock return) = E[(Stock return)2 ] E[Stock return]2 , by taking the equation Var (Stock return) = 2 t into account, we have: pu 2 + (1 p)d 2 pu + (1 p)d 2 = 2 t. e t d . ud

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

34 / 38

u, d and contd
The next step is to replace p with
e t d ud . t

We then approximate the quantity e exponential function:

, using the Taylor expansion of the (t)2 . 2

e t 1 + t +

Note however that the term (t)2 has negligible size. This gives (after some further calculations) the following equation: (1 + t)(u + d) ud (1 + 2t) = 2 t. One solution of the above equation is the pair: t t u and d =e =e The above construction of a binomial tree was proposed by Cox, Ross and Rubinstein in 1979.
M. Anthropelos (Un. of Piraeus) Binomial Model Spring 2011 35 / 38

Facts about the Binomial Tree Construction

There is a standard and constant relation between u and d: u d = 1. u and d do not depend on the expected return of the stock price or the subjective probabilities. What matters the most is the volatility of the stock price. Volatility and interest rate are constant during the life of the option.

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

36 / 38

Binomial Tree and Option Pricing, an example

Lets consider the following example of American put option pricing: S(0) = 50, K = 50, r = 10% (continuous compounding), = 40%, T t = 5 months = 0.417 and t = 1 month = 0.083 Therefore, u = e
t

= 1.224 and d = e

= 0.891.

And the neutral-risk probability of the upward movement q=

e r t d ud

= 0.508.

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

37 / 38

Binomial Tree and Option Pricing, an example

The stock price and the American put option prices are given in the graph of the binomial tree:

M. Anthropelos (Un. of Piraeus)

Binomial Model

Spring 2011

38 / 38