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Binomial Trees
Binomial Trees
Chapter 11
Portfolio
= 0.25
is riskless when 22 1 = 18 or
22 1
18
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 )
S0
S0u
u
S0d
d
Options, Futures, and Other Derivatives
7th Edition, Copyright John C. Hull
Generalization
(continued)
Consider
S0u u
S0d d
The
or
u f d
S 0u S 0 d
Options, Futures, and Other Derivatives
7th Edition, Copyright John C. Hull
Generalization
(continued)
Value
Generalization
(continued)
for we obtain
= [ pu + (1 p)d ]erT
Substituting
where
e d
p
ud
rT
10
p as a Probability
It
S0
(1
p)
S0u
u
S0d
d
11
Risk-Neutral Valuation
When
12
S0
(1
p)
S0u = 22
u = 1
S0d = 18
d = 0
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
3
2
5
6
0.
0.34
77
S0u = 22
u = 1
S0d = 18
d = 0
14
15
A Two-Step Example
Figure 11.3, page 242
24.2
22
19.8
20
18
16.2
Each
16
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
17
60
50
4.1923
1.4147
40
72
0
48
4
9.4636
32
20
18
60
50
5.0894
1.4147
40
72
0
48
4
12.0
32
20
19
Delta
Delta
20
Choosing u and d
One way of matching the volatility is to set
u e
d 1 u e
21
ad
ud
( r r f ) t
22