Binomial Trees

Chapter 11

Options, Futures, and Other

Derivatives, 7th Edition, Copyright

A Simple Binomial Model

A stock

price is currently $20

In 3 months it will be either $22 or $18

Stock Price = $22

Stock price = $20
Stock Price = $18

Options, Futures, and Other Derivatives

7th Edition, Copyright John C. Hull

A Call Option (Figure 11.1, page 238)

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

Options, Futures, and Other Derivatives

7th Edition, Copyright John C. Hull

Setting Up a Riskless Portfolio

Consider

Portfolio

= 0.25

the Portfolio: long shares

short 1 call option

is riskless when 22 1 = 18 or

22 1

18

Options, Futures, and Other Derivatives

7th Edition, Copyright John C. Hull

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 0.120.25 = 4.3670

Options, Futures, and Other Derivatives

7th Edition, Copyright John C. Hull

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 )

Options, Futures, and Other Derivatives

7th Edition, Copyright John C. Hull

Generalization (Figure 11.2, page 239)

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

S0

S0u
u
S0d
d
Options, Futures, and Other Derivatives
7th Edition, Copyright John C. Hull

Generalization
(continued)

the portfolio that is long shares and

short 1 derivative

Consider

S0u u
S0d d
The

portfolio is riskless when S0u u = S0d d

or

u f d

S 0u S 0 d
Options, Futures, and Other Derivatives
7th Edition, Copyright John C. Hull

Generalization
(continued)
Value

of the portfolio at time T is

S0u u
Value of the portfolio today is
(S0u u)erT
Another expression for the portfolio
value today is S0 f
Hence
= S0 (S0u u )erT
Options, Futures, and Other Derivatives
7th Edition, Copyright John C. Hull

Generalization
(continued)

for we obtain
= [ pu + (1 p)d ]erT

Substituting

where

e d
p
ud
rT

Options, Futures, and Other Derivatives

7th Edition, Copyright John C. Hull

10

p as a Probability
It

is natural to interpret p and 1-p as probabilities

of up and down movements
The value of a derivative is then its expected
payoff in a risk-neutral world discounted at the
risk-free rate

S0

(1
p)

S0u
u
S0d
d

Options, Futures, and Other Derivatives

7th Edition, Copyright John C. Hull

11

Risk-Neutral Valuation
When

the probability of an up and down

movements are p and 1-p the expected stock price
at time T is S0erT
This shows that the stock price earns the risk-free
rate
Binomial trees illustrate the general result that to
value a derivative we can assume that the
expected return on the underlying asset is the riskfree rate and discount at the risk-free rate
This is known as using risk-neutral valuation

Options, Futures, and Other Derivatives

7th Edition, Copyright John C. Hull

12

Original Example Revisited

p

S0

(1
p)

S0u = 22
u = 1
S0d = 18
d = 0

Since p is the probability that gives a return on the

stock equal to the risk-free rate. We can find it from
20e0.12 0.25 = 22p + 18(1 p )
which gives p = 0.6523
Alternatively, we can use the formula

e rT d e 0.120.25 0.9
p

0.6523
ud
1.1 0.9
Options, Futures, and Other Derivatives
7th Edition, Copyright John C. Hull

13

Valuing the Option Using RiskNeutral Valuation

S0

3
2
5
6
0.
0.34
77

S0u = 22
u = 1
S0d = 18
d = 0

The value of the option is

e0.120.25 (0.65231 + 0.34770)
= 0.633
Options, Futures, and Other Derivatives
7th Edition, Copyright John C. Hull

14

Irrelevance of Stocks Expected

Return
When we are valuing an option in terms of
the price of the underlying asset, the
probability of up and down movements in
the real world are irrelevant
This is an example of a more general result
stating that the expected return on the
underlying asset in the real world is
irrelevant

Options, Futures, and Other Derivatives

7th Edition, Copyright John C. Hull

15

A Two-Step Example
Figure 11.3, page 242

24.2
22
19.8

20
18

16.2

Each

time step is 3 months

K=21, r=12%
Options, Futures, and Other Derivatives
7th Edition, Copyright John C. Hull

16

Valuing a Call Option

Figure 11.4, page 243

D
Value

22

24.2
3.2

at node B is
B
20
2.0257
e0.120.25(0.65233.2
+ 0.34770)
= 2.0257 19.8
A
E
0.0
Value1.2823
at node A is
18
C = 1.2823
e0.120.25(0.65232.0257 + 0.34770)

0.0

16.2
0.0

Options, Futures, and Other Derivatives

7th Edition, Copyright John C. Hull

17

A Put Option Example

Figure 11.7, page 246

K = 52, time step =1yr

r = 5%

60
50
4.1923

1.4147
40

72
0
48
4

9.4636

32
20

Options, Futures, and Other Derivatives

7th Edition, Copyright John C. Hull

18

What Happens When an Option

is American (Figure 11.8, page 247)
D

60
50
5.0894

1.4147
40

72
0
48
4

12.0

32
20

Options, Futures, and Other Derivatives

7th Edition, Copyright John C. Hull

19

Delta
Delta

() 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 varies from node to node

Options, Futures, and Other Derivatives

7th Edition, Copyright John C. Hull

20

Choosing u and d
One way of matching the volatility is to set
u e

d 1 u e

where is the volatility andt is the length

of the time step. This is the approach used
by Cox, Ross, and Rubinstein

Options, Futures, and Other Derivatives

7th Edition, Copyright John C. Hull

21

The Probability of an Up Move

p

ad
ud

a e rt for a nondividen d paying stock

a e ( r q ) t for a stock index wher e q is the dividend
yield on the index
a e

( r r f ) t

for a currency where r f is the foreign

risk - free rate

a 1 for a futures contract

Options, Futures, and Other Derivatives

7th Edition, Copyright John C. Hull

22