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Options Pricing Using Binomial Trees

Options Pricing Using Binomial Trees


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Published by Gouthaman Balaraman

A brief introduction to the techniques of pricing options using binomial trees is discussed. This is meant to be a short heuristic approach to options theory pricing using binomial trees. For a more basic introduction, you may want to look into "Introduction to Options Pricing Using Binomial Trees" under my scribd account.
You can also follow http://gouthamanbalaraman.com/blog/option-model-handbook-part-I-introduction-to-option-models.html for the latest article.

A brief introduction to the techniques of pricing options using binomial trees is discussed. This is meant to be a short heuristic approach to options theory pricing using binomial trees. For a more basic introduction, you may want to look into "Introduction to Options Pricing Using Binomial Trees" under my scribd account.
You can also follow http://gouthamanbalaraman.com/blog/option-model-handbook-part-I-introduction-to-option-models.html for the latest article.

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Published by: Gouthaman Balaraman on Jul 27, 2008
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Options Pricing Using Binomial Trees

Gouthaman S. Balaraman, Ph.D. goutham@gatech.edu Keywords: Risk-Neutral valuation, Black-Scholes formula, No-Arbitrage hypothesis, European Vanilla options (with or without dividens), Amercan Vanilla options (with or without dividends), Bisection method, Newton-Raphson method, Ito’s lemma, Implied volatility, Implied volatility trees.



The bedrock of options pricing is the risk-neutral valuation principle, which relates the expected value of a financial product at a future time to its current price. This is consistent with no-arbitrage hypothesis. Vanilla options have a theoretical price given by the BlackScholes formula. We briefly touch upon these two aspects here. In the next section of this write-up, we make use of risk-neutral valuation in constructing a binomial model to price European, and American options with and without dividends. Towards the end we take up the case of constructing implied volatility tree, which incorporates volatility smile of the underlying.


Risk-Neutral Valuation

An important general principle in options pricing is the risk-neutral valuation. According to this principle, the expected return from a stock at time T , E (ST ), is the risk free value of the current stock price: E (ST ) = S0 erT The continuous compounding risk-free rate is r and the current stock price is S0 . The principal of risk-neutral valuation can be used to create a binomial model for price movement, and subsequently a method to value options.


Black Scholes Formula

Value of a vanilla European call option, struck at K with time T to maturity, can be derived using the above mentioned risk-neutral valuation principle. The payoff of the call at maturity on an underlying with price V (at maturity) is max(V − K, 0). The expected value of this payoff can be found, assuming a geometric brownian motion price movement for the underlying as, ∞ E [max(V − K, 0)] = (V − K )g (V )dV,

where g (V ) is the probability density function of V such that log(V ) is normally distributed with standard deviation w. Thus the current value of the call is C = e−rT E [max(V − K, 0)]

which after a lengthy calculation comes out to be C = S0 N (d1 ) − Ke−rT N (d2 ) (1)

where S0 is the current price of the underlying, the risk free rate is r, the volatility of the underlying is σ , ln[S0 /K ] + (r + σ 2 /2)T √ d1 = σ T √ ln[S0 /K ] + (r − σ 2 /2)T √ d2 = = d1 − σ T σ T and N (x) is the cumulative distribution function. The put-call parity relates the price of the put and call prices, and is given as: C − P = S0 − e−rT K Put-call parity and Eq. (1) can be used to arrive at put prices. For the case where the underlying has a continuous payout (dividend) q , the Black-Scholes formula can be extended to yield, c = S0 e−qT N (d1 ) − Ke−rT N (d2 ) where, d1 = ln(S0 /K ) + (r − q + σ 2 /2)T √ σ T √ d2 = d1 − σ T


Binomial Tree
One Step Tree

Let us construct a tree whose pricing is given as shown in the figure (1) below, restricting to time t0 and t1 . Initial price of the stock is S0 at t0 and has the option of moving to S0 u or S0 d at time t1 . Let p be the probability of the price to rise from S0 to S0 u. Calculating the expected return from the stock at t1 and making use of risk-neutral valuation, E (St1 ) = pS0 u + (1 − p)S0 d = S0 er(t1 −t0 ) we get p = er(t1 −t0 ) − d u−d (2)

We need to chose appropriate values for the parameters u and d which can be obtained from equating the variance of the return to σ 2 ∆t. The variance of the stock price return on the binomial tree is: pu2 + (1 − p)d2 − [pu + (1 − p)d]2 = σ 2 ∆t

S u2

S0u p S0

S0 1−p S0d S0 d2




Figure 1: A sample binomial tree diagram. On ignoring terms of order higher than ∆t2 and making use of ud = 1, we get u = eσ
√ ∆t

d = e−σ



One can make use of the above construction to value an option. Let f be the current value of an option on a stock. Let the payoff of the option after one step (time T ) on a binomial tree be fu and fd for up and down movement respectively of the stock. The value of the option in this case is given as: f = e−rT [pfu + (1 − p)fd ].


Valuing European Options using Binomial Tree

Let us look at the simple example of valuing vanilla European option on an underlying (nondividend paying stock) with a current price S0 , strike price K , time to maturity T , risk-free interest rate r, stock volatility σ . Steps to calculate the value of option: • Build the basic binomial tree of stock price in future time, starting with S0 at time t0 . At time t1 , the possible stock price values are (S0 u,S0 d). At time t2 , the possible values are (S0 d2 , S0 ,S0 u2 ) and so on until time to maturity T . A sample tree is shown in Fig. (1). • Calculate the payoff from the option at the time of maturity, which for a European call is max(ST − K, 0). • Calculate the value of the option for all nodes at earlier time steps by using risk-neutral valuation, working backwards until time t0 . One can follow this procedure to find the value of the option at initial time t0 . Sample calculation is shown in Fig. (2).

C0 6.8 6.6 6.4 6.2 6.0 5.8 5.6 20 40 60 80 100 n

Figure 2: Plot of the value of a 5-month European call C0 vs. number of time steps n on a non-dividend paying stock when stock price is $50, strike price is $50, risk free rate is 10% per annum, and the volatility is is 40% per annum. The calculation is checked against the Black-Scholes value(red curve).


Valuing European Options on Dividend-Paying Stock

Here we extend the binomial model for valuing options pricing when the underlying is a dividend paying stock. The dividend is paid on an ex-dividend date, and can be a percentage of the stock price (known dividend yield) or some fixed dollar amount (known dollar dividend). 2.3.1 Known Dividend Yield

Let us start with a simple case where there is just one single dividend, and δ is the known dividend yield. The prices of stocks for time i∆t prior to the stock going ex-dividend, the nodes on the tree correspond to stock prices S0 uj di−j , j = 0, 1, . . . , i

and if the time i∆t is after the stock goes ex-dividend, the nodes correspond to stock prices S0 ∗ (1 − δ )uj di−j , j = 0, 1, . . . , i

Now, instead of just one dividend yield, if we have many dividend yields during the life of an option, the nodes at time i∆t correspond to stock prices S0 (1 − δi )uj di−j where δi is the total dividend yeild associate with all ex-dividend dates between zero and time i∆t. 2.3.2 Known Dollar Amount

When the cash dividend payment of a stock is known, the value of European option on such an underlying is analyzed by assuming that the stock price is the sum of two components:

C0 6.4 6.3 6.2 6.1 6.0 5.9 n 0 20 40 60 80

Figure 3: Plot of the value of a 5-month European call C0 vs. number of time steps n on a dividend paying stock when stock price is $52, strike price is $50, risk free rate is 10% per annum, and the volatility is 40% per annum, dividend is $2.06, and ex-dividend date is three and a half months. The calculation is checked against the Black-Scholes value(red curve). riskless component that corresponds to the known dividends during the life of the option and a risky option. The riskless component at any time, is the present value of the dividends during the life of the option, discounted from the ex-dividend dates to the present at the risk-free rate. When the option matures the dividends would have been paid and the riskless component vanishes. Therefore Black-Scholes formula can be used to price in this case if the stock price is reduced by the present value of all the dividend during the life of the options. Discounting in this case should be done from the ex-dividend date at the risk-free rate. However the volatility for the risky component σ ∗ is not the same as the volatility of the whole stock price. See Appendix 1 for more details. A binomial model for this case can be built by making use of the above argument. Let D be the dividend paid, τ the ex-dividend date, and S the stock price. The stock price of the risky component S ∗ at time i∆t is given by S∗ = S and S ∗ = S − De−r(τ −i∆t) i∆t < τ Thus using parameters σ ∗ , p, u, and d a tree can be constructed to model S ∗ . By adding to the stock price the present value of future dividends, a tree representing S ∗ can be converted to that representing S . At time i∆t < τ , the nodes on this tree correspond to the stock prices ∗ j i− j S0 u d + De−r(τ −i∆t) , j = 0, 1, . . . , i and for i∆t > τ , nodes correspond to
∗ j i−j S0 ud ,

i∆t > τ

j = 0, 1, . . . , i.

Results from a sample calculation is shown in Fig. (3).


Valuing American Option using Binomial Trees

European option can be exercised only at the time of maturity, but an American option can be exercised anytime before the maturity. Method used to value American option is very similar to that of the European option, except that we need to incorporate the fact that the option could be exercised early. In the case of American option, the value of the option at any node in the binomial tree is the greater of the value calculated by backward induction (like in European options), and the payoff from early exercise of option. By arbitrage arguments one can show that it is never optimal to exercise early, an American call option on a non-dividend paying stock (Appendix 2), and its value is given by the Black-Scholes formula. Let us consider an American put option, maturing at time T = 1yr struck at price K = 100, risk-free interest r = 5%, and volatility of stock σ = 15%. Let us take a simple twostep binomial model, as shown in Fig (4). One can calculate using Eqns. (2,3), parameters
a) Stock Price b) Option Value

$123.63 $111.19 $100.00 $89.94 $80.89 C B A











Figure 4: An example of valuing an American put option on a binomial tree. (a) The standard binomial tree of stock prices. (b) The value of an American put option on this binomial tree. u, d, and p, and hence set up the binomial tree for stock prices, as shown in Fig. (4a). In Fig. (4b) the option value at maturity, has filled in. By backward induction, the value of the option at nodes A and B are $1.9867 and $12.4694 respectively. For a European option, this would indeed be the values at these nodes. Since early exercise is allowed for an American option, the cost of immediate exercise at node B , which is $15.06, is greater than cost of hedging the option. So the value of the option at node B should indeed be $15.06. Now by back calculating, the value of the option at C is 7.1322. In Fig. (5), I calculate the value of the American put option for this example, as a function of number of iterations. Extending this to incorporate dividend paying stocks can be done as we did to value European options on dividend paying stocks.


Implied Volatility Trees

Options traded in the marked have a price, called the market price. Using the market price of an option, one can back-calculate the volatility, called the Black-Scholes implied volatility,

associated with the market price of the option. In other words, implied volatility is the value of volatility along with other parameters, that would yield a Black-Scholes value equal to the market value. In practice, the implied volatilities for a variety of options (on a given stock) with different strikes and time until expiration, have different values. This nonconstant implied volatility questions the following two assumptions that have been assumed in pricing options so far: • The underlying follows a geometric Brownian motion with constant volatility. • There is no arbitrage opportunity in the market. Here we will see how to compute implied volatility and discuss how this used in constructing implied volatility trees that price options consistent with the market value.


Computing Implied Volatility

The Black-Scholes formula for a call option is given by Eq. (1), which is a function of strike price K , volatility σ , stock price St , and interest rate r. However this formula cannot be inverted to get a formula for the volatility in terms of the other parameters and the call value C . Thus one often resorts to numerical methods, like bisection method, and NewtonRaphson method. Essentially, we have a function C (σ ) with a given value C , and we need to find the value σ such that C (σ ) = C . Bisection Method Bisection method starts with two guesses for the implied volatility σ< and σ> such that σ< < σ < σ> . In order to arrive at this guess, one makes use of the fact that greater volatility leads to greater option value, (i.e.) C (σ< ) < C (σ ) = C < C (σ> ). • Compute σn = (σ< + σ> )/2, and find the value of C (σn ). • If C (σn ) < C then set the new value for σ< = σn , and if C (σn ) > C then set σ> = σn .
P0 7.10 7.05 7.00 6.95 6.90 6.85 6.80 n 10 20 30 40 50 60

S0 $100, K $105, r

5 , Σ

15 , T


Figure 5: Plot of American put option on a non-dividend-paying stock, as a function of the number of iterations in the binomial model.

Bisection n σn 1 0.1 2 0.05 3 0.075 4 0.0875 5 0.09375 6 0.096875 7 0.0953125 8 0.0945313 9 0.0949219 10 0.0947266 11 0.0948242 12 0.0947754

Method C (σn ) 8.86916 6.5799 7.65725 8.253 8.55901 8.71361 8.63619 8.59757 8.61687 8.60722 8.61204 8.60963

Newton-Raphson Method 1 0.1 8.86916 2 0.094808 8.61124 3 0.0947829 8.61 Table 1: Table of iterations σn and the correponding C (σn ) for Bisection method and NewtonRaphson method, calculated to an accuracy = 10−4 . Parameters considered are S0 = $100, K = $100, C = $8.61, r = 3% and T = 2yr. • Repeat steps (1) and (2) until σn satisfies |C (σn ) − C | < , where accuracy. is desired the

Newton Raphson Method Let f (σ ) = C (σ ) − C , and we need to find σ such that f (σ ) = 0. Let σ0 be our initial guess, such that it is ‘close enough’ to σ . The general formula for the nth guess is given as σn = σn−1 − f (σn−1 ) f (σn−1 )

df where f (σn−1 ) = dσ σ =σn−1 . One can continue this iteration process until |C (σn ) − C | < , for a given desired accuracy parameter . Bisection method has a much slower rate of convergence in comparison to NewtonRaphson method, but the Bisection method is guaranteed to converge while the NewtonRaphson method is known can have issues with convergence in specific cases. Calculations from a sample calculation is shown in Table (1).


Constructing Implied Volatility Trees

We have so far used standard trees which is exactly the same for all options, irrespective of the strike level or time to expiration. However, as discussed above, the market value of options vary with different strike price and time to expiration on the same underlying. This situation cannot be remedied within the framework of standard trees, and hence led to the development of implied volatility trees. The implied volatility tree is constructed with a given set of option values as input, and constructed in such a way that the implied volatility tree always prices the input options consistently with the market price. Hence implied volatility trees are useful in calculating hedge parameters consistent with the market, and in valuing non-standard and exotic options. Here I underline the methodology for constructing implied volatility trees discussed by Derman and Kani [3] for a given set of European option prices as input. From a given set of market values for a set of European options for different strike level, and time to expiration, one can make use of interpolation/extrapolation to construct implied volatility as a function of the strike and time to expiration, given as σ (K, t). The implied volatility tree is constructed by method of induction. Let us assume one has already constructed the prices of the first n time steps that match the implied volatilities of all options with all strikes out to that time period. Let si and λi be the already known stock prices and Arrow-Debreu prices1 respectively for the n nodes at time tn . Let r be the riskfree interest rate for the time step (tn , tn+1 ). Our goal is to fix the stock prices for n + 1 nodes at time tn+1 and n transition probabilities pi for the transition from level n to level n + 1. To solve for 2n + 1 unknowns, we have n equation for the value of forwards and n equations for the value of options, all expiring at tn+1 making a total of 2n equations. We use the additional degree of freedom to fix the value of the center of the tree to coincide with the spot price S0 , if there are odd number of nodes for a given level; and have the average of the natural logarithms of the two central nodes’ stock price equal the logarithm of todays stock price, if there are even number of nodes at a given level. Forward Price Equation The n forward prices Fi of the stock one time period ∆t later, at n nodes at time tn is Fi = si er∆t = pi Si+1 + (1 − pi )Si (4)

Options Price Equation The n options price C (K, tn+1 ) expiring at tn+1 , one for each strike K equal to si , the known stock price at tn .

C (K, tn+1 ) = e

− r ∆t

[λj pj + λj +1 (1 − pj +1 )] max(Sj +1 − K, 0)
j =1

which can be rewritten for a strike K equals si in the form of known stock prices si and forwards Fi

er∆t C (si , tn+1 ) = λi pi (Si+1 − si ) +
j =i+1

λj (Fj − si )



−r (tn −t0 )

The Arrow-Debreu price of a node is the probability of reaching that node discounted by a factor , where tn − t0 represents the time between today and the time where the node is.

On solving Eq. (4,5) for Si+1 and transition probability pi in terms of Si , we get Si+1 = pi Si [er∆t C (si , tn+1 ) − Σ] − λi si (Fi − Si ) [er∆t C (si , tn+1 ) − Σ] − λi (Fi − Si ) Fi − Si = Si+1 − Si (6) (7)

where Σ = n j =i+1 λj (Fj − si ). If n + 1 is odd, then we can fix the price of the central node for i = n/2 + 1 equal to S0 , today’s spot price. Then we can calculate the stock price Sj for nodes j > n/2 + 1 iteratively by using Eq. (6,7). Thus we fix the prices for the upper half of each level. On the other hand if n + 1 is even, then we constrain Si and Si+1 for i = (n + 1)/2 to 2 /Si+1 . Substituting this relation into Eq. (6) gives, satisfy Si = S0 Si+1 = S0 [er∆t C (S0 , tn+1 ) + λi S0 − Σ] λi Fi − er∆t C (S0 , tn+1 ) + Σ i = (n + 1)/2 (8)

Once we have the price for this initial node, we can continue to fix the nodes for the upper half by making use of Eq. (6). Similarly all the nodes below the central node at a given level can be known from the put prices P (si , tn+1 ), given by the formula Si = where Σ =
j =1

Si+1 [er∆t P (si , tn+1 ) − Σ ] + λi si (Fi − Si+1 ) [er∆t P (si , tn+1 ) − Σ ] + λi (Fi − Si+1 )


λj (si − Fj ).

Representative results from the calculation for the example given in Ref. [3] is shown in Table (2). Note: The prices at every node has to satisfy the condition Fi < Si+1 < Fi+1 , otherwise riskless arbitrage is allowed. If the above inequality is violated, then the stock price is ignored and replaced in such a way that the logarithmic spacing between this node and its adjacent node the same as that between corresponding nodes at the previous level.

Appendix 1
Let S follow geometric Brownian motion given as dS = µ S dt + σ S dWt . We define a new stochastic process S ∗ after discounting the future dividend payouts (can be generalised for more than one dividend payouts as well) as S ∗ = S − D e−r(τ −t)

t (years) Sj 0 100 1 90.4837 110.517 2 79.2866 100 120.301 3 71.3336 90.4366 110.575 130.076

λj 1 0.361937 0.608508 0.114641 0.423299 0.403825 0.0508735 0.213965 0.380012 0.26908

t (years) Sj 4 58.7514 79.2783 100 120.369 139.169 5 54.349 71.2027 90.3895 110.632 130.1 147.74

λj 0.013883 0.103719 0.255762 0.323699 0.189858 0.00852321 0.0505726 0.148055 0.253054 0.26151 0.138994

Table 2: The stock prices and the Arrow-Debreu prices for zero to five years on an implied tree. The smile here is given as σ (S ) = 15 − 0.05S %. These prices can be compared with the example shown in Ref. [3]. where D is the dividend paid out at time the ex-dividend date τ . Using Ito’s lemma we can write down the stochastic differential equation for S ∗ (S, t) as dS ∗ = ∂S ∗ 1 ∂ 2S ∗ ∂S ∗ ∂S ∗ + a(S, t) + b(S, t)2 dt + b ( S, t ) dWt ∂t ∂S 2 ∂S 2 ∂S dS ∗ = (µS − Drer(τ −t) )dt + σS dWt which can be rewritten as dS ∗ = µ S ∗ dt + σ S ∗ dWt where, µS − Dre−r(τ −t) S − De−r(τ −t) σS σ∗ = S − De−r(τ −t) Thus the Black-Scholes option pricing formula can be modified to handle lumpy dividend payouts by considering a geometric Brownian motion for the stock with a volatility at time t, σS σS σ∗ = ≈ − r ( τ − t ) S − De S−D and a reduced initial price S ∗ = S − De−r(τ −t) µ∗ = Chriss ([1] page 160) remarks that the Black-Scholes formula for lumpy dividend payout can be calculated by plugging in the new (time-dependent) volatility σ ∗ directly into the Black-Scholes formula, which seems suspect to me as Black-Scholes formula is meant to hold for constant volatility. However it would be appropriate the to use the approximate value [2] σ ∗ = σS/(S − D) instead, where it is applicable.

if S is given by dS = a(S, t)dt + b(S, t)dWt . In this case we get

Appendix 2: Early Exercise of American Options
Here we show that, for an American call option on a non-dividend paying stock, it is never optimal to exercise early. In order to prove this, we start with an American option on a non-dividend paying stock struck at K maturing at time T . At some arbitrary time t before maturity, let the option be in the money. Now we consider two cases: • Exercise the option at the time t. • Hold the option until its expiration and exercise it. For the above two situations, we look at the worth of the two investments at the time of maturity T . For case one, to fund the exercise of the option at time t, we sell a bond for K maturing at time T , and invest the proceeds of the sale to buy stock at K . At maturity we have the stock and owe an amount K er(T −t) , a net worth of ST − K er(T −t) For the second case, the value of the investment at maturity is max(ST − K, 0), which is worth more than the case one for positive interest rate r. Thus we always have, ST − er(T −t) K < max(ST − K, 0) Thus it is never optimal to exercise early. However, this is no longer true if the underlying is a dividend-paying stock.

[1] Neil A Chriss, Black-Scholes and Beyond: Option Pricing Models [2] John C. Hull, Options, Futures, and Other Derivatives [3] E. Derman and I. Kani, Goldman Sachs Quantitative Strategies Research Notes, 1994

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