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Finance II

Unit 3: Binomial Options Pricing Model

Mathematical Sciences Foundation

Delhi

www.msfonline.in

Copyright c 2010 Mathematical Sciences Foundation.

This handout forms part of a Mathematical Sciences Foundation programme.

Further details of this and other MSF programmes can be obtained from

the MSF website (www.mathscifound.org). You can also call MSF at 011-

29230401 and 65182616, or email courses.msf@gmail.com.

All rights reserved; no part of this publication may be reproduced, stored,

transmitted or utilised in any form or by any means, without written per-

mission from the Mathematical Sciences Foundation.

Contents

1 Call Options 3

2 Put Options 7

3 Put-call Parity 9

4 Binomial Options Pricing Model 10

5 Pricing American Options 16

6 Risk-Neutral Valuation 18

A Solutions to Exercises 19

1

2 Mathematical Sciences Foundation: Course in Mathematical Finance

With this Unit we begin our study of options, which oﬀer additional ﬂex-

ibility as compared to futures. Over the next few Units, we shall learn how

to use them to ﬁne tune the risk characteristics of a portfolio.

Options have a long history. One of the early records is of the philosopher

Thales of Miletus (624-547 BC), who made a fortune through options on olive

presses. According to Aristotle, one winter Thales paid a small fee for the ﬁrst

right to rent these presses during the olive season. If the harvest was good

and the presses in demand (they are used to produce olive oil), Thales could

exercise his options and then sublet the presses at a much higher rent. If the

harvest was poor and nothing was to be gained from renting the presses, he

could let his right lapse. As it happened, the harvest was good, and Thales

made a large proﬁt.

Incidentally, Thales was also credited by later generations with introducing

deduction into geometry and providing the ﬁrst proofs of basic results such

as the ASA rule for congruence of triangles. Aristotle said of Thales that for

him, “The primary question was not What do we know, but How do we know

it.”

The ﬁrst detailed mathematical treatment of options is in Louis Bachelier’s

1900 thesis, where he created a Brownian motion model to estimate the risks

involved with various investment strategies based on options. His work was

not signiﬁcantly improved till the 1973 publications of Fischer Black, Myron

Scholes and Robert Merton. These described what is now called the Black-

Scholes Model and gave an extensive analysis of options pricing and the use

of options in hedging and speculation. The model came into being just as the

use of computers was becoming widespread and the result was an explosion

in the use of options. Scholes and Merton received the Nobel Prize in 1997,

Black having unfortunately passed away two years earlier.

In this unit, we shall carry out a study of options and their use in hedging.

However, instead of the Black-Scholes model, we shall use a simpliﬁed discrete

version known as the Binomial Options Pricing Model or BOPM. BOPM was

introduced in 1978 by William Sharpe and extended in 1979 by J. C. Cox,

S. A. Ross and M. Rubinstein.

Study Guide

You should ﬁnish this Unit in two weeks.

Finance II, Unit 3: BOPM 3

Writer

Holder

C

t = 0

Writer

Holder

X Asset

t = T

Figure 1: The structure of a European call option signed at time t = 0 with

expiration time t = T, exercise price X, and call premium C. The dashed arrows

at the t = T stage indicate that the trade is optional.

1 Call Options

In forwards and futures both parties are committed to a future trade. Natu-

rally, each would desire the chance to drop out if the gain from the contract

becomes less than is available on the open market. This desire creates an

opening for a new kind of contract, in which one party pays the other a fee

for the right to cancel the trade. Such a contract is called an option and

comes in two ﬂavours, depending on which party buys the right to choose.

NSE introduced trading in options in June 2001. The number of

traded options grew from 1.2 million during 2001-2 to 18.2 million

during 2005-6.

In a European Call Option the holder buys the right to make a future

purchase, without the obligation to do so:

1. The holder pays the writer an initial fee (the call premium) to buy

the contract. The contract details an amount of the underlying asset,

an expiration date, and an exercise price (or strike price).

2. On the expiration date, the holder may pay the writer the exercise

price.

3. If the holder pays up, the writer must deliver the speciﬁed amount of

the underlying asset.

4 Mathematical Sciences Foundation: Course in Mathematical Finance

X 320 330 340 350 360 370 380

C 29.75 20.65 10.95 6.10 3.75 2.35 1.50

Table 1: The table shows the closing call premiums on June 3, 2005, for a range

of exercise prices that were available for call options on TISCO stock. The options

expired on June 30, 2005.

If the exchange happens, we say the contract has been exercised.

A variation on the above structure is an American Call Option — such

a contract can be exercised at any time between its birth and expiry. Thus

the holder of an American call can either exercise it at any time by paying

the exercise price X, or let it lapse. Since an American call gives the holder

more rights than a European call, it is obvious that it will have at least as

high a premium. In other words, let C

A

be the premium of an American call

and C

E

the premium of a European call such that both calls have the same

underlying asset, expiry time and exercise price. Then C

A

≥ C

E

.

A call option can be written on various kinds of assets, e.g., commodi-

ties, bonds, stocks, stock indices, and futures. It can be traded through an

exchange or directly. When a call is traded on an exchange, the exchange

standardizes the expiry times, the amounts of underlying asset, and the ex-

ercise price. Typically, options for a particular asset will be available with a

range of exercise prices. Naturally, options with diﬀerent exercise prices also

have diﬀerent premiums. (See Table 1)

Exercise 1.1 Suppose two call options are identical, except that one has a

higher exercise price. Which one will have a higher call premium?

Like futures, options can be traded at any time of their life to new holders.

The price at which they are sold is again called their premium. The task

before us is to ﬁnd the correct premium at which a call should be sold. To

do this, we have to establish how good a deal is being oﬀered to the holder.

Figure 2 illustrates how the ﬁnal payoﬀ to the holder of a European call

option depends on the spot price of the underlying asset at the expiry time.

If the ﬁnal spot price S

T

is greater than the exercise price X, the holder

exercises the call and proﬁts by S

T

−X. Otherwise, she does not exercise it

(since it is cheaper for her to buy the asset by paying S

T

in the market) and

the ﬁnal payoﬀ is zero. Thus the ﬁnal payoﬀ is given by

max{0, S

T

−X},

Finance II, Unit 3: BOPM 5

Payoﬀ

S

T X

Figure 2: The payoﬀ to the holder of a European call option expiring at T, as a

function of the ﬁnal spot price S

T

of the underlying asset.

and this is also the premium of the call at time T.

Since the ﬁnal payoﬀ is guaranteed to be non-negative, the No Arbitrage

Principle (and common sense!) dictates that the call premium must be non-

negative:

C ≥ 0 (1)

Another insight comes from observing that the holder of a European call

has a superior ﬁnal payoﬀ as compared to the holder of a futures with the

same asset, expiry time, and exercise price. Therefore, the call premium must

be higher than the value of the corresponding futures. If the asset generates

no income or costs, we get:

C ≥ S −Xe

−rT

(2)

Combining the bounds (1) and (2) we get the following bounds for the pre-

mium of a European call:

C ≥ max{0, S −Xe

−rT

} (3)

Exercise 1.2 Write down the form (3) will have if the underlying asset

generates either known income or a continuous dividend yield.

Exercise 1.3 Show that (3) is also valid for an American call on an asset

without income.

An upper bound on C can be obtained if it is known that the asset price

cannot be negative. In this case, the payoﬀ from the call is always less than

6 Mathematical Sciences Foundation: Course in Mathematical Finance

5 10 15 20 25

2.5

5

7.5

10

12.5

15

17.5

Figure 3: This graph compares the premiums of calls on Maruti stock (stars)

with the lower bound (diamonds) given by (3). The horizontal axis represents the

time interval May 23, 2005, to June 29, 2005. The calls expired on June 30, 2005.

During this period, the price of a Maruti share ranged between Rs. 435 and Rs.

478.

or equal to S

T

. Hence the value of the call is less than the value of owning

the asset:

C ≤ S (4)

For example, this inequality is valid when the underlying asset is a stock

(whose price cannot be negative) but not when it is a futures (whose value

can be negative).

Exercise 1.4 Show that (4) is also valid for an American call on an asset

without income.

Bounds are useful if they are not too far away from the actual values.

Figure 3 illustrates how the lower bound given by (3) is usually reasonably

close to the actual premium values. The upper bound given by (3), though

correct, is too large to be useful.

Here is our ﬁrst surprise concerning call options:

An American call has the same value as a European call with the same

parameters, if the underlying asset generates no income.

Consider an American call with expiry at T and exercise price X. Let C

t

be its premium at a time t < T, and S

t

the spot price of the underlying asset

at that time. From Equation (3), we see that

C

t

≥ S

t

−Xe

−r(T−t)

,

Finance II, Unit 3: BOPM 7

Writer

Holder

P

t = 0

Writer

Holder

Asset X

t = T

Figure 4: The structure of a European put option signed at time t = 0 with

expiration time t = T, exercise price X, and put premium P.

and hence C

t

> S

t

−X. Since S

t

−X is the payoﬀ from exercising the call,

we see that it is never optimal to exercise the call. It would be better to sell

it. Thus an American call will never be exercised before expiry, and hence

has the same value as a European call with the same parameters.

This conclusion fails when the asset generates income, because then the

early exercise of an American call could have the added beneﬁt of bringing

us a share of this income.

2 Put Options

A put option is the reverse of a call option. Here, the holder buys the right

to sell the asset to the writer.

In a European Put Option the holder buys the right to make a future

sale, without the obligation to do so, in the following manner:

1. The holder pays the writer an initial fee (the put premium) to buy

the contract.

2. On the expiration date, the holder may deliver the underlying asset to

the writer.

3. If the holder delivers the asset, the writer must pay the exercise price

(or strike price).

Our earlier remarks about calls apply as well to puts. In particular, we

8 Mathematical Sciences Foundation: Course in Mathematical Finance

Payoﬀ

S

T X

Figure 5: The payoﬀ to the holder of a European put option expiring at T, as a

function of the ﬁnal spot price S

T

of the underlying asset.

have American Put Options, which give the holder the right to exercise

the contract before the expiry time. The premium of an American put will

be at least as much as the premium of a European put with the same pa-

rameters. And this time there are no surprises — in general, the premium

of the American call will be strictly greater (even when the asset generates

no income).

Figure 5 shows the ﬁnal payoﬀ from a European put expiring at T and

with exercise price X. The formula for this ﬁnal payoﬀ is

max{0, X −S

T

}.

This immediately tells us that the put premium P at time t = 0 must satisfy

P ≥ 0. Next, we observe that the payoﬀ to the put holder is always at least

as much as that to the writer of a futures with the same parameters. Hence

the put has greater value. For an asset without income, this gives:

P ≥ Xe

−rT

−S (5)

Combining (5) with P ≥ 0 we get the following lower bound for the premium

of a European put:

P ≥ max{0, Xe

−rT

−S} (6)

Exercise 2.1 Write down the form (6) will have if the underlying asset

generates either known income or a continuous dividend yield.

An upper bound on P can be obtained if it is known that the asset price

cannot be negative. In this case, the maximum possible payoﬀ from a put is

Finance II, Unit 3: BOPM 9

its exercise price X. Hence the premium of a European put cannot exceed

the present value of X:

P ≤ Xe

−rT

(7)

Exercise 2.2 How will you modify the bounds (6) and (7) for an American

put on an asset without income whose spot price cannot be negative?

3 Put-call Parity

We have already found it useful to compare calls and puts with futures.

Figure 6 collects the payoﬀ patterns for a European call, a European put,

and a futures, with the same underlying asset, expiry time T, and exercise

price X. The comparison shows that for S

T

≥ X the holders of the call and

the futures receive the same payoﬀ. For S

T

≤ X, the writer of the put and

the holder of the futures receive the same payoﬀ. Thus, if we simultaneously

become the holder of the call and the writer of the put, our ﬁnal payoﬀ at

T will exactly match that of the holder of the futures. Therefore, the initial

value of our portfolio must match that of the futures:

C −P = S −X e

−rT

.

This equation is called Put-Call Parity. It can be rearranged as

P +S = C +Xe

−rT

It is important to note that Put-Call Parity is only valid for European options.

On the other hand, it is valid for all underlying assets, whether they generate

income or not.

Exercise 3.1 Give a formal proof of Put-Call Parity by means of the Method

of Replicating Portfolios.

An interesting application of Put-Call Parity is that by rearranging it, we

can create a combination of three assets that mimics the fourth one. For

example, we see that a portfolio which has Xe

−rT

cash and is also long one

call and short one share, is equivalent to being long one put. This kind of

manipulation is called Financial Engineering.

Exercise 3.2 Consider options on a stock following GBM with drift param-

eter µ. One may reason as follows: If µ is higher then the expected value

10 Mathematical Sciences Foundation: Course in Mathematical Finance

Payoﬀ

S

T

X

S

T

X

S

T

X

Figure 6: The payoﬀs to the holders of (from left to right) a European call, a

European put, and a futures — each with the same underlying asset, expiry time

T, and exercise price X.

of S

T

is higher, so the call premium should increase while the put premium

should decrease. Evaluate this conclusion in light of Put-Call Parity.

Let us summarize the progress we have made:

• We have lower bounds for the option premiums.

• When the asset price must be positive, we have upper bounds as well.

• When the asset generates no income, American and European calls

have the same premium.

• European options satisfy Put-Call Parity.

This is about as far as we can get with the No Arbitrage Principle alone.

Signiﬁcant further progress is only possible by combining the No Arbitrage

Principle with models of asset price ﬂuctuations. We shall now begin this

task, using the models developed in Unit 2 of Finance II. It is relevant to

note here that these particular models have been found to be acceptable for

stock prices, but not necessarily for other prices. Thus, from now on, asset

should really be read as stock.

4 Binomial Options Pricing Model

The Binomial Options Pricing Model, or BOPM, is a discrete model for

computing the value of an option, whether European or American. BOPM

Finance II, Unit 3: BOPM 11

is based on the Binomial Tree Model (Unit 2). In this model we break up

the time span [0, T] into n equal parts, and imagine that over each part the

asset price can either move up by a factor U or down by a factor D. Thus,

the basic object is the following branch:

S

SU

SD

We remark that typically U > 1 > D, but the only requirement from the

model is U > D.

One-Step BOPM

First, consider the n = 1 case. Imagine a European call option on this asset

which expires at T and has exercise price X. If its initial premium is C, then

the evolution of its value over the interval [0, T] is represented by:

C

C

u

= max{0, SU −X}

C

d

= max{0, SD−X}

Here, C

u

is the call payoﬀ if the asset price moves up, and C

d

is the call

payoﬀ if the asset price moves down.

It is clear that C

u

> C

d

. So the call value goes up if the asset price goes up,

and down if the asset price goes down. Now, if we become the writer of the

call the position reverses. Proﬁts from the asset will be cancelled by losses

from the call. If we have the right amounts of long asset and short calls

the ﬂuctuations can exactly cancel and we shall have a risk-free portfolio.

Thus suppose we own h units of the asset and write 1 call. The value of this

portfolio evolves according to the following branch:

hS −C

hSU −C

u

hSD−C

d

12 Mathematical Sciences Foundation: Course in Mathematical Finance

For this portfolio to be risk-free, we need hSU −C

u

= hSD−C

d

. We solve

this for h:

h =

C

u

−C

d

S(U −D)

The ratio h is called the option’s delta, and this process of creating a

risk-free portfolio is called delta-hedging.

Since the portfolio is risk-free, its initial value equals the present value of

its value at T. Thus,

hS −C = e

−rT

(hSU −C

u

).

Substituting the value of h, we get:

C = e

−rT

_

qC

u

+ (1 −q)C

d

¸

, where q =

e

rT

−D

U −D

(8)

Exercise 4.1 Verify Equation (8).

Exercise 4.2 Use the No Arbitrage Principle to show that D < e

rT

< U,

and hence 0 < q < 1.

Two-Step BOPM

We now let the above process happen twice in succession, cutting the time

interval [0, T] into the equal parts [0, T/2] and [T/2, T]. Then we have the

following picture for the evolution of the spot price:

S

SU

SD

SU

2

SUD

SD

2

We label the corresponding payoﬀs from the call expiring at T as follows:

Finance II, Unit 3: BOPM 13

C

C

u

C

d

C

uu

C

ud

C

dd

Note that we have

C

uu

= max{0, SU

2

−X}

C

ud

= max{0, SUD −X}

C

dd

= max{0, SD

2

−X}

Applying the one-step BOPM to the branches with nodes at C

u

and C

d

gives:

C

u

= e

−rT/2

_

qC

uu

+ (1 −q)C

ud

¸

C

d

= e

−rT/2

_

qC

ud

+ (1 −q)C

dd

¸

where q =

e

−rT/2

−D

U −D

. We apply the one-step BOPM once again, to the

branch with node at C, to get:

C = e

−rT/2

_

qC

u

+ (1 −q)C

d

¸

= e

−rT

_

q

2

C

uu

+ 2q(1 −q)C

ud

+ (1 −q)

2

C

dd

¸

Exercise 4.3 Suppose we have a two-step BOPM with S = 100, X = 100,

U = 1.1, D = 0.9, r = 10% and T = 1. Show that C = 10.714.

Many-Step BOPM

A certain pattern in the call premium formulas should now be evident. First,

we list all the possible ﬁnal spot prices. Over n steps, these are

S

T

= SU

k

D

n−k

, k = 0, 1, . . . , n.

14 Mathematical Sciences Foundation: Course in Mathematical Finance

The payoﬀ from the call corresponding to the ﬁnal spot price SU

k

D

n−k

is

max{0, SU

k

D

n−k

−X}

We multiply this payoﬀ by the binomial expression

_

n

k

_

q

k

(1 −q)

n−k

, where

q =

e

−rT/n

−D

U −D

. Finally, we sum all these terms and multiply by e

−rT

.

The general BOPM formula is thus obtained:

C = e

−rT

n

k=0

_

n

k

_

q

k

(1 −q)

n−k

max{0, SU

k

D

n−k

−X}

We have given this formula as a reasonable generalization of the one and

two-step BOPM. You may enjoy proving it by induction!

This formula for C has a very interesting form. First, the division by e

rT

represents a present value. This present value is taken of a weighted average

of the payoﬀs from the call at expiry. The weights are the probabilities

associated with a binomial random variable with parameters n and q. Thus

one is led to interpreting q as a probability, which is possible since we have

already determined that 0 < q < 1. Since it arose out of making the process

risk-free, it is called the risk neutral probability.

For European puts, we have a similar analysis, except that the call payoﬀs

at expiry are replaced by the put payoﬀs:

P = e

−rT

n

k=0

_

n

k

_

q

k

(1 −q)

n−k

max{X −SU

k

D

n−k

, 0}

Exercise 4.4 Show that the BOPM formulas for put and call premiums

satisfy Put-Call Parity.

An interesting aspect of the BOPM is that the premium depends on T

(represented by n), S, X, r, and volatility (represented by U, D), but not on

the real-world probabilities of price increase or decrease.

Finance II, Unit 3: BOPM 15

5 10 15 20 25

5

10

15

Figure 7: A comparison of actual premiums (stars) of call options on Maruti stock

with the predictions from a 10-step BOPM. (See Example 4.5)

Estimating BOPM parameters

To put BOPM to honest work, we need estimates of the parameters U and

D. We have already seen one way of making these estimates in Unit 2 of

Finance II, where we matched the binomial tree to the lognormal model and

obtained

U

.

= e

σ

√

△t

, D

.

= e

−σ

√

△t

,

where σ is the volatility parameter in the lognormal model. In the same unit,

we also described how to obtain σ from the historical data.

Example 4.5 Figure 7 compares the actual closing premiums of European

call options on Maruti stock with the theoretical ones calculated by a 10-step

BOPM. The options expired on June 30, 2005, and had an exercise price of

Rs 460. For the BOPM calculations, we have assumed an annual risk-free

rate of 5% and taken the volatility to be σ = 0.26. 2

The main issue here is the choice of σ. This example illustrates that the

model works well if we have the right value of σ, but how do we obtain it?

It is true that we have earlier given a way of estimating σ from historical

prices, but a little reﬂection throws up some obvious problems. How much

data should we use? What should be its frequency? Unfortunately, our

choices in these matters can have a dramatic impact on the value that we

get for σ.

One solution that has become popular is to work back from the options

themselves. Find the σ that makes BOPM give accurate values for one set

16 Mathematical Sciences Foundation: Course in Mathematical Finance

of options and use it in calculations for others! We will return to this idea in

the next chapter.

5 Pricing American Options

Recall that American calls have the same value as the corresponding Euro-

pean call, so that case is already covered. We will now see how the BOPM

can be used to compute the premium of an American put. In applying BOPM

to an American option, we assume that the decision to exercise or not can

only be made at the nodes of the branching process.

We start by considering the one-step situation:

S

SU

SD

The corresponding diagram for the payoﬀs from the American put is:

P

∗

P

∗

u

= max{0, X −SU}

P

∗

d

= max{0, X −SD}

Here, we use P

∗

to refer to the value of the American put. If we use P to

indicate the value of the corresponding European put, we have P

∗

u

= P

u

and

P

∗

d

= P

d

, since an American put held till expiry is equivalent to a European

put.

Now, at the starting point, the holder has the option of either exercising the

put right away, or holding it till expiry. If he holds it till expiry, it becomes a

European put, and its value is given by the BOPM for European puts: it is

e

−rT

_

qP

∗

u

+(1−q)P

∗

d

¸

. On the other hand, exercising it immediately is worth

X −S. He will obviously take that step which gives more value. Therefore:

P

∗

= max

_

e

−rT

_

qP

∗

u

+ (1 −q)P

∗

d

¸

, X −S

_

.

Finance II, Unit 3: BOPM 17

This one-step BOPM for American puts can be used to piece together an

n-step BOPM in the usual way. We show below how the two-step BOPM is

created.

P

∗

P

∗

u

P

∗

d

P

∗

uu

P

∗

ud

P

∗

dd

We work our way back from the right end of the tree. We ﬁrst note that:

P

∗

uu

= max{X −SU

2

, 0}

P

∗

ud

= max{X −SUD, 0}

P

∗

dd

= max{X −SD

2

, 0}

Now, we apply the one-step BOPM to the two second-stage branches:

P

∗

u

= max

_

X −SU, e

−rT/2

_

qP

∗

uu

+ (1 −q)P

∗

ud

¸_

P

∗

d

= max

_

X −SD, e

−rT/2

_

qP

∗

ud

+ (1 −q)P

∗

dd

¸_

Finally, we apply the one-step BOPM to the ﬁrst branch:

P

∗

= max

_

X −S, e

−rT/2

_

qP

∗

u

+ (1 −q)P

∗

d

¸_

By now it should be clear how the process will work for an n-step tree.

This is an easy process to implement numerically. However, it does not lead

to a closed form solution (unlike the case of European options), and so does

not give analytic insight.

Example 5.1 Consider a 1-step BOPM for an American put with T = 1,

e

rT

= 1.05, S = 100, U = 1.1, D = 0.9 and X = 100. Then the risk-neutral

probability is given by

q =

1.05 −0.9

1.1 −0.9

= 0.75

18 Mathematical Sciences Foundation: Course in Mathematical Finance

We have the ﬁnal payoﬀs

P

∗

u

= max{0, X −SU} = max{0, 100 −110} = 0

P

∗

d

= max{0, X −SD} = max{0, 100 −90} = 10

The put premium is therefore given by

P

∗

= max

_

X −S, e

−rT

_

qP

∗

u

+ (1 −q)P

∗

d

¸_

= max{0,

1

1.05

×0.25 ×10}

= 2.38

In this case, it is best to not exercise early as that has a zero payoﬀ. On

the other hand, if we change X to 105, the payoﬀ from exercising early is

superior. 2

6 Risk-Neutral Valuation

Let us take another look at the structure of the BOPM formulas for European

call premiums. We observed earlier that the premium turns out to be the

present value of the expected future payoﬀs, calculated using the risk-neutral

probability q. A little later, we saw that the premium of a European put has

the same form.

Further insight into q comes by considering risk neutral investors. Since

they are blind to risk they do not demand any compensation for it. If all

investors are risk neutral, then the expected value of any asset will grow at

the risk-free rate. Now consider a one-step binary tree for an asset, over a

time T. Let the up move have probability p. The expected ﬁnal value of the

asset is

E[S

T

] = pSU + (1 −p)SD.

We assume a world of risk neutral investors. Then we have

E[S

T

] = e

rT

S =⇒ pSU + (1 −p)SD = e

rT

S =⇒ p =

e

rT

−D

U −D

= q.

So the risk neutral probability q can also be interpreted as the probability

of an up move in a risk neutral world. Yet another description of q that

emerges from this calculation is that it is the probability that makes today’s

spot price equal to the present value of the expected future payoﬀ.

Finance II, Unit 3: BOPM 19

Our results for European options extend immediately to any derivative

whose ﬁnal payoﬀ depends only on the ﬁnal spot price of the underlying asset.

We shall call such a derivative a European derivative. The extension of

the BOPM formula to such a derivative is automatic since our calculations

of European options premiums are independent of the formula for the ﬁnal

payoﬀs.

As an instance of this general approach, we can re-derive the formula for

the value of a futures contract. The payoﬀs at the end of an n-step binomial

tree are SU

k

D

n−k

−X, and hence the initial value of the futures is given by

V = e

−rT

n

k=0

_

n

k

_

q

k

(1 −q)

n−k

_

SU

k

D

n−k

−X

_

= e

−rT

_

S

n

k=0

_

n

k

_

(qU)

k

((1 −q)D)

n−k

−X

_

= e

−rT

_

S(qU + (1 −q)D)

n

−X

_

= e

−rT

_

Se

rT

−X

_

= S −Xe

−rT

Exercise 6.1 Consider a contract which will pay you the square of the price

of the underlying asset at a future time T. What is the correct price for this

contract?

A Solutions to Exercises

Exercise 1.2 We compare with the value of the corresponding futures to get:

C ≥ max{0, S −I −Xe

−rT

} (Income has present value I)

C ≥ max{0, Se

−qT

−Xe

−rT

} (Income has continuous dividend yield q)

Exercise 2.1

P ≥ max{0, Xe

−rT

−S +I} (Income has present value I)

P ≥ max{0, Xe

−rT

−Se

−qT

} (Income has continuous dividend yield q)

Exercise 2.2 If an American put is exercised at t = 0, there is a payoﬀ of X−S >

Xe

−rT

−S. So the lower bound can be improved to

P ≥ max{0, X −S}

20 Mathematical Sciences Foundation: Course in Mathematical Finance

The upper bound similarly changes to P ≤ X.

Exercise 3.1 Create the following portfolios at time t = 0:

Portfolio A: 1 put and 1 share.

Portfolio B: 1 call and Xe

−rT

cash.

Exercise 3.2 The same reasoning would suggest put prices would fall. But Put-

Call Parity says put and call prices move together — the only resolution is that

the prices must be independent of the expected future asset price.

Exercise 4.4 Note that for any number x,

max{0, x} −max{0, −x} = x

Therefore,

max{0, SU

k

D

n−k

−X} −max{0, X −SU

k

D

n−k

} = SU

k

D

n−k

−X

Substitute this in the n-step BOPM formula for C −P:

C −P = e

−rT

n

k=0

_

n

k

_

q

k

(1 −q)

n−k

max{0, SU

k

D

n−k

−X}

−e

−rT

n

k=0

_

n

k

_

q

k

(1 −q)

n−k

max{0, X −SU

k

D

n−k

}

= e

−rT

n

k=0

_

n

k

_

q

k

(1 −q)

n−k

_

SU

k

D

n−k

−X

¸

= e

−rT

_

S

n

k=0

_

n

k

_

(qU)

k

((1 −q)D)

n−k

−X

_

= e

−rT

[S(qU + (1 −q)D)

n

−X]

= e

−rT

_

Se

rT

−X

¸

= S −Xe

−rT

Exercise 6.1 An n-step BOPM gives the value of the contract as

V

n

= e

−rT

n

k=0

_

n

k

_

q

k

(1 −q)

n−k

S

2

U

2k

D

2(n−k)

= S

2

e

−rT

[qU

2

+ (1 −q)D

2

]

n

= S

2

e

−rT

[e

rT/n

(U +D) −1]

n

Finance II, Unit 3: BOPM 21

If we take U = e

σ

√

T/n

and D = e

−σ

√

T/n

, and then let n → ∞, we obtain the

value

V = S

2

e

(r+σ

2

)T

This limit takes some eﬀort to calculate. A hint: substitute the power series

expansions and consider the ﬁrst couple of terms. Using the log function also

helps. It is also possible to attack the problem via L’Hˆopital’s Rule.

2

Mathematical Sciences Foundation: Course in Mathematical Finance

With this Unit we begin our study of options, which oﬀer additional ﬂexibility as compared to futures. Over the next few Units, we shall learn how to use them to ﬁne tune the risk characteristics of a portfolio. Options have a long history. One of the early records is of the philosopher Thales of Miletus (624-547 BC), who made a fortune through options on olive presses. According to Aristotle, one winter Thales paid a small fee for the ﬁrst right to rent these presses during the olive season. If the harvest was good and the presses in demand (they are used to produce olive oil), Thales could exercise his options and then sublet the presses at a much higher rent. If the harvest was poor and nothing was to be gained from renting the presses, he could let his right lapse. As it happened, the harvest was good, and Thales made a large proﬁt. Incidentally, Thales was also credited by later generations with introducing deduction into geometry and providing the ﬁrst proofs of basic results such as the ASA rule for congruence of triangles. Aristotle said of Thales that for him, “The primary question was not What do we know, but How do we know it.” The ﬁrst detailed mathematical treatment of options is in Louis Bachelier’s 1900 thesis, where he created a Brownian motion model to estimate the risks involved with various investment strategies based on options. His work was not signiﬁcantly improved till the 1973 publications of Fischer Black, Myron Scholes and Robert Merton. These described what is now called the BlackScholes Model and gave an extensive analysis of options pricing and the use of options in hedging and speculation. The model came into being just as the use of computers was becoming widespread and the result was an explosion in the use of options. Scholes and Merton received the Nobel Prize in 1997, Black having unfortunately passed away two years earlier. In this unit, we shall carry out a study of options and their use in hedging. However, instead of the Black-Scholes model, we shall use a simpliﬁed discrete version known as the Binomial Options Pricing Model or BOPM. BOPM was introduced in 1978 by William Sharpe and extended in 1979 by J. C. Cox, S. A. Ross and M. Rubinstein.

Study Guide

You should ﬁnish this Unit in two weeks.

Such a contract is called an option and comes in two ﬂavours. in which one party pays the other a fee for the right to cancel the trade. without the obligation to do so: 1. depending on which party buys the right to choose. exercise price X. The holder pays the writer an initial fee (the call premium) to buy the contract. the writer must deliver the speciﬁed amount of the underlying asset. NSE introduced trading in options in June 2001. The dashed arrows at the t = T stage indicate that the trade is optional. 3. The number of traded options grew from 1. This desire creates an opening for a new kind of contract. In a European Call Option the holder buys the right to make a future purchase. .2 million during 2005-6. and call premium C. Naturally. the holder may pay the writer the exercise price. an expiration date.2 million during 2001-2 to 18. On the expiration date. each would desire the chance to drop out if the gain from the contract becomes less than is available on the open market. 2. and an exercise price (or strike price). Unit 3: BOPM Writer C Holder t=0 Writer X Asset 3 Holder t=T Figure 1: The structure of a European call option signed at time t = 0 with expiration time t = T . If the holder pays up.Finance II. The contract details an amount of the underlying asset. 1 Call Options In forwards and futures both parties are committed to a future trade.

for a range of exercise prices that were available for call options on TISCO stock. Typically. except that one has a higher exercise price. Thus the holder of an American call can either exercise it at any time by paying the exercise price X. Figure 2 illustrates how the ﬁnal payoﬀ to the holder of a European call option depends on the spot price of the underlying asset at the expiry time. Otherwise. the amounts of underlying asset.35 1.75 20. Which one will have a higher call premium? Like futures.10 3. stock indices. (See Table 1) Exercise 1. A variation on the above structure is an American Call Option — such a contract can be exercised at any time between its birth and expiry. we say the contract has been exercised. Naturally. and the exercise price. expiry time and exercise price. bonds. the exchange standardizes the expiry times.g.4 Mathematical Sciences Foundation: Course in Mathematical Finance X C 320 330 340 350 360 370 380 29.. commodities. or let it lapse. In other words. If the exchange happens. options with diﬀerent exercise prices also have diﬀerent premiums. e. A call option can be written on various kinds of assets. and futures. 2005. The options expired on June 30. Thus the ﬁnal payoﬀ is given by max{0. .65 10. It can be traded through an exchange or directly. When a call is traded on an exchange. let CA be the premium of an American call and CE the premium of a European call such that both calls have the same underlying asset. options for a particular asset will be available with a range of exercise prices. To do this. it is obvious that it will have at least as high a premium.1 Suppose two call options are identical. options can be traded at any time of their life to new holders. The price at which they are sold is again called their premium. she does not exercise it (since it is cheaper for her to buy the asset by paying ST in the market) and the ﬁnal payoﬀ is zero. Then CA ≥ CE . stocks. 2005. The task before us is to ﬁnd the correct premium at which a call should be sold. If the ﬁnal spot price ST is greater than the exercise price X.95 6. we have to establish how good a deal is being oﬀered to the holder.75 2. ST − X}.50 Table 1: The table shows the closing call premiums on June 3. Since an American call gives the holder more rights than a European call. the holder exercises the call and proﬁts by ST − X.

and exercise price. Since the ﬁnal payoﬀ is guaranteed to be non-negative. In this case.Finance II. Unit 3: BOPM 5 Payoﬀ X function of the ﬁnal spot price ST of the underlying asset. we get: C ≥ S − Xe−rT (2) Combining the bounds (1) and (2) we get the following bounds for the premium of a European call: C ≥ max{0. Exercise 1. An upper bound on C can be obtained if it is known that the asset price cannot be negative. S − Xe−rT } (3) Exercise 1.2 Write down the form (3) will have if the underlying asset generates either known income or a continuous dividend yield. as a and this is also the premium of the call at time T . the payoﬀ from the call is always less than . ST Figure 2: The payoﬀ to the holder of a European call option expiring at T . Therefore. the No Arbitrage Principle (and common sense!) dictates that the call premium must be nonnegative: C≥0 (1) Another insight comes from observing that the holder of a European call has a superior ﬁnal payoﬀ as compared to the holder of a futures with the same asset.3 Show that (3) is also valid for an American call on an asset without income. If the asset generates no income or costs. the call premium must be higher than the value of the corresponding futures. expiry time.

Here is our ﬁrst surprise concerning call options: An American call has the same value as a European call with the same parameters. we see that Ct ≥ St − Xe−r(T −t) . is too large to be useful. 2005. 2005. 435 and Rs. 2005. this inequality is valid when the underlying asset is a stock (whose price cannot be negative) but not when it is a futures (whose value can be negative). The calls expired on June 30. if the underlying asset generates no income. Figure 3 illustrates how the lower bound given by (3) is usually reasonably close to the actual premium values. The horizontal axis represents the time interval May 23. During this period.6 Mathematical Sciences Foundation: Course in Mathematical Finance 17.4 Show that (4) is also valid for an American call on an asset without income. or equal to ST . Consider an American call with expiry at T and exercise price X.5 10 7. the price of a Maruti share ranged between Rs. 478. and St the spot price of the underlying asset at that time. Hence the value of the call is less than the value of owning the asset: C≤S (4) Bounds are useful if they are not too far away from the actual values. From Equation (3). though correct. For example.5 5 2. Exercise 1. The upper bound given by (3). Let Ct be its premium at a time t < T . . to June 29.5 5 10 15 20 25 Figure 3: This graph compares the premiums of calls on Maruti stock (stars) with the lower bound (diamonds) given by (3).5 15 12.

and hence has the same value as a European call with the same parameters. 2 Put Options A put option is the reverse of a call option. If the holder delivers the asset. the holder may deliver the underlying asset to the writer. This conclusion fails when the asset generates income. and hence Ct > St − X. The holder pays the writer an initial fee (the put premium) to buy the contract. we . without the obligation to do so. In a European Put Option the holder buys the right to make a future sale. Since St − X is the payoﬀ from exercising the call. In particular. the holder buys the right to sell the asset to the writer. exercise price X. and put premium P . 2. 3. It would be better to sell it. Our earlier remarks about calls apply as well to puts. the writer must pay the exercise price (or strike price). because then the early exercise of an American call could have the added beneﬁt of bringing us a share of this income. Unit 3: BOPM Writer P Holder t=0 Writer Asset X 7 Holder t=T Figure 4: The structure of a European put option signed at time t = 0 with expiration time t = T .Finance II. Here. we see that it is never optimal to exercise the call. Thus an American call will never be exercised before expiry. in the following manner: 1. On the expiration date.

the premium of the American call will be strictly greater (even when the asset generates no income). the maximum possible payoﬀ from a put is . Next. X − ST }. as a have American Put Options. This immediately tells us that the put premium P at time t = 0 must satisfy P ≥ 0. An upper bound on P can be obtained if it is known that the asset price cannot be negative. which give the holder the right to exercise the contract before the expiry time. For an asset without income. we observe that the payoﬀ to the put holder is always at least as much as that to the writer of a futures with the same parameters. Figure 5 shows the ﬁnal payoﬀ from a European put expiring at T and with exercise price X.8 Mathematical Sciences Foundation: Course in Mathematical Finance Payoﬀ X function of the ﬁnal spot price ST of the underlying asset. ST Figure 5: The payoﬀ to the holder of a European put option expiring at T . Xe−rT − S} (6) Exercise 2. And this time there are no surprises — in general. this gives: P ≥ Xe−rT − S (5) Combining (5) with P ≥ 0 we get the following lower bound for the premium of a European put: P ≥ max{0.1 Write down the form (6) will have if the underlying asset generates either known income or a continuous dividend yield. In this case. The premium of an American put will be at least as much as the premium of a European put with the same parameters. Hence the put has greater value. The formula for this ﬁnal payoﬀ is max{0.

we can create a combination of three assets that mimics the fourth one. This equation is called Put-Call Parity. Thus. Exercise 3. is equivalent to being long one put. our ﬁnal payoﬀ at T will exactly match that of the holder of the futures.2 How will you modify the bounds (6) and (7) for an American put on an asset without income whose spot price cannot be negative? 3 Put-call Parity We have already found it useful to compare calls and puts with futures. with the same underlying asset.Finance II. Unit 3: BOPM 9 its exercise price X.1 Give a formal proof of Put-Call Parity by means of the Method of Replicating Portfolios. we see that a portfolio which has Xe−rT cash and is also long one call and short one share. One may reason as follows: If µ is higher then the expected value . a European put. An interesting application of Put-Call Parity is that by rearranging it. The comparison shows that for ST ≥ X the holders of the call and the futures receive the same payoﬀ. expiry time T . Therefore. it is valid for all underlying assets. whether they generate income or not. the writer of the put and the holder of the futures receive the same payoﬀ. This kind of manipulation is called Financial Engineering. It can be rearranged as P + S = C + Xe−rT It is important to note that Put-Call Parity is only valid for European options. Exercise 3. if we simultaneously become the holder of the call and the writer of the put.2 Consider options on a stock following GBM with drift parameter µ. On the other hand. For ST ≤ X. For example. Figure 6 collects the payoﬀ patterns for a European call. and exercise price X. Hence the premium of a European put cannot exceed the present value of X: P ≤ Xe−rT (7) Exercise 2. and a futures. the initial value of our portfolio must match that of the futures: C − P = S − X e−rT .

from now on. using the models developed in Unit 2 of Finance II. we have upper bounds as well. Evaluate this conclusion in light of Put-Call Parity. so the call premium should increase while the put premium should decrease. a European put. and a futures — each with the same underlying asset. Let us summarize the progress we have made: • We have lower bounds for the option premiums. expiry time T . • When the asset price must be positive. but not necessarily for other prices. It is relevant to note here that these particular models have been found to be acceptable for stock prices. asset should really be read as stock. and exercise price X. • When the asset generates no income. of ST is higher. We shall now begin this task. is a discrete model for computing the value of an option. BOPM . Thus. • European options satisfy Put-Call Parity. Signiﬁcant further progress is only possible by combining the No Arbitrage Principle with models of asset price ﬂuctuations. American and European calls have the same premium. whether European or American. or BOPM.10 Mathematical Sciences Foundation: Course in Mathematical Finance Payoﬀ X ST X ST X ST Figure 6: The payoﬀs to the holders of (from left to right) a European call. This is about as far as we can get with the No Arbitrage Principle alone. 4 Binomial Options Pricing Model The Binomial Options Pricing Model.

but the only requirement from the model is U > D. One-Step BOPM First. If its initial premium is C. Imagine a European call option on this asset which expires at T and has exercise price X. It is clear that Cu > Cd . the basic object is the following branch: SU S SD We remark that typically U > 1 > D. T ] is represented by: Cu = max{0. and imagine that over each part the asset price can either move up by a factor U or down by a factor D. SD − X} Here. SU − X} C Cd = max{0.Finance II. The value of this portfolio evolves according to the following branch: hSU − Cu hS − C hSD − Cd . if we become the writer of the call the position reverses. Unit 3: BOPM 11 is based on the Binomial Tree Model (Unit 2). consider the n = 1 case. and Cd is the call payoﬀ if the asset price moves down. In this model we break up the time span [0. Thus suppose we own h units of the asset and write 1 call. then the evolution of its value over the interval [0. If we have the right amounts of long asset and short calls the ﬂuctuations can exactly cancel and we shall have a risk-free portfolio. Thus. and down if the asset price goes down. T ] into n equal parts. So the call value goes up if the asset price goes up. Now. Proﬁts from the asset will be cancelled by losses from the call. Cu is the call payoﬀ if the asset price moves up.

we get: C = e−rT qCu + (1 − q)Cd . Then we have the following picture for the evolution of the spot price: SU 2 SU S SD SD 2 We label the corresponding payoﬀs from the call expiring at T as follows: SUD . and this process of creating a risk-free portfolio is called delta-hedging. Substituting the value of h. Thus. Since the portfolio is risk-free. and hence 0 < q < 1. T /2] and [T /2. We solve this for h: Cu − Cd h= S(U − D) The ratio h is called the option’s delta. we need hSU − Cu = hSD − Cd . hS − C = e−rT (hSU − Cu ). its initial value equals the present value of its value at T . where q = erT − D U −D (8) Two-Step BOPM We now let the above process happen twice in succession.1 Verify Equation (8). Exercise 4. cutting the time interval [0. Exercise 4.12 Mathematical Sciences Foundation: Course in Mathematical Finance For this portfolio to be risk-free. T ] into the equal parts [0.2 Use the No Arbitrage Principle to show that D < erT < U. T ].

SD 2 − X} Applying the one-step BOPM to the branches with nodes at Cu and Cd gives: Cu = e−rT /2 qCuu + (1 − q)Cud Cd = e−rT /2 qCud + (1 − q)Cdd e−rT /2 − D .3 Suppose we have a two-step BOPM with S = 100.Finance II. to the U −D branch with node at C. . n. . . U = 1. Show that C = 10. k = 0. X = 100. . Unit 3: BOPM 13 Cuu Cu C Cd Cdd Note that we have Cuu = max{0.714. SU 2 − X} Cud = max{0.1. 1. First. Over n steps. D = 0. . We apply the one-step BOPM once again. r = 10% and T = 1. these are ST = SU k D n−k .9. we list all the possible ﬁnal spot prices. Many-Step BOPM A certain pattern in the call premium formulas should now be evident. to get: C = e−rT /2 qCu + (1 − q)Cd Cud where q = = e−rT q 2 Cuu + 2q(1 − q)Cud + (1 − q)2 Cdd Exercise 4. SUD − X} Cdd = max{0.

and volatility (represented by U. but not on the real-world probabilities of price increase or decrease. it is called the risk neutral probability. The weights are the probabilities associated with a binomial random variable with parameters n and q. except that the call payoﬀs at expiry are replaced by the put payoﬀs: n P =e −rT k=0 n k q (1 − q)n−k max{X − SU k D n−k . where k The general BOPM formula is thus obtained: n e−rT /n − D . U −D C=e −rT k=0 n k q (1 − q)n−k max{0. Finally. SU k D n−k − X} k We have given this formula as a reasonable generalization of the one and two-step BOPM. we have a similar analysis.4 Show that the BOPM formulas for put and call premiums satisfy Put-Call Parity. D). You may enjoy proving it by induction! This formula for C has a very interesting form. r. An interesting aspect of the BOPM is that the premium depends on T (represented by n). Since it arose out of making the process risk-free. 0} k Exercise 4. we sum all these terms and multiply by e−rT .14 Mathematical Sciences Foundation: Course in Mathematical Finance The payoﬀ from the call corresponding to the ﬁnal spot price SU k D n−k is max{0. For European puts. First. S. X. . SU k D n−k − X} We multiply this payoﬀ by the binomial expression q= n k q (1 − q)n−k . the division by erT represents a present value. This present value is taken of a weighted average of the payoﬀs from the call at expiry. which is possible since we have already determined that 0 < q < 1. Thus one is led to interpreting q as a probability.

where we matched the binomial tree to the lognormal model and obtained √ . (See Example 4. where σ is the volatility parameter in the lognormal model. D = e−σ △t . but a little reﬂection throws up some obvious problems. we have assumed an annual risk-free rate of 5% and taken the volatility to be σ = 0. 2005. This example illustrates that the model works well if we have the right value of σ. How much data should we use? What should be its frequency? Unfortunately. Find the σ that makes BOPM give accurate values for one set . but how do we obtain it? It is true that we have earlier given a way of estimating σ from historical prices. we need estimates of the parameters U and D. √ U = eσ △t . In the same unit. One solution that has become popular is to work back from the options themselves.5) Estimating BOPM parameters To put BOPM to honest work.Finance II. Unit 3: BOPM 15 15 10 5 5 10 15 20 25 Figure 7: A comparison of actual premiums (stars) of call options on Maruti stock with the predictions from a 10-step BOPM. . our choices in these matters can have a dramatic impact on the value that we get for σ. The options expired on June 30.5 Figure 7 compares the actual closing premiums of European call options on Maruti stock with the theoretical ones calculated by a 10-step BOPM. We have already seen one way of making these estimates in Unit 2 of Finance II. and had an exercise price of Rs 460. For the BOPM calculations. we also described how to obtain σ from the historical data.26. Example 4. 2 The main issue here is the choice of σ.

we use P ∗ to refer to the value of the American put. If he holds it till expiry. X − S . or holding it till expiry. since an American put held till expiry is equivalent to a European put. 5 Pricing American Options Recall that American calls have the same value as the corresponding European call. On the other hand. we assume that the decision to exercise or not can only be made at the nodes of the branching process. We will now see how the BOPM can be used to compute the premium of an American put. we have Pu = Pu and ∗ Pd = Pd . . at the starting point. so that case is already covered. If we use P to ∗ indicate the value of the corresponding European put. In applying BOPM to an American option. and its value is given by the BOPM for European puts: it is ∗ ∗ e−rT qPu + (1 −q)Pd . We start by considering the one-step situation: SU S SD The corresponding diagram for the payoﬀs from the American put is: ∗ Pu = max{0. X − SU} P∗ ∗ Pd = max{0. Now. X − SD} Here. exercising it immediately is worth X − S. the holder has the option of either exercising the put right away. it becomes a European put.16 Mathematical Sciences Foundation: Course in Mathematical Finance of options and use it in calculations for others! We will return to this idea in the next chapter. He will obviously take that step which gives more value. Therefore: ∗ ∗ P ∗ = max e−rT qPu + (1 − q)Pd .

we apply the one-step BOPM to the ﬁrst branch: ∗ ∗ P ∗ = max X − S. e−rT /2 qPud + (1 − q)Pdd Finally.1 Consider a 1-step BOPM for an American put with T = 1. e−rT /2 qPuu + (1 − q)Pud ∗ ∗ ∗ Pd = max X − SD. 0} ∗ Pdd = max{X − SD 2 . Example 5.9 . We ﬁrst note that: ∗ Puu = max{X − SU 2 . Then the risk-neutral probability is given by 1.05. we apply the one-step BOPM to the two second-stage branches: ∗ ∗ ∗ Pu = max X − SU.9 = 0. e−rT /2 qPu + (1 − q)Pd By now it should be clear how the process will work for an n-step tree. D = 0. S = 100.1. Unit 3: BOPM 17 This one-step BOPM for American puts can be used to piece together an n-step BOPM in the usual way. We show below how the two-step BOPM is created. However. ∗ Puu ∗ Pu P∗ ∗ Pd ∗ Pud ∗ Pdd We work our way back from the right end of the tree. and so does not give analytic insight. erT = 1.75 q= 1.05 − 0.9 and X = 100. 0} ∗ Pud = max{X − SUD.1 − 0.Finance II. U = 1. This is an easy process to implement numerically. 0} Now. it does not lead to a closed form solution (unlike the case of European options).

we saw that the premium of a European put has the same form.25 × 10} 1. We assume a world of risk neutral investors.38 In this case. If all investors are risk neutral. 100 − 110} = 0 ∗ Pd = max{0. 100 − 90} = 10 The put premium is therefore given by ∗ ∗ P ∗ = max X − S. Now consider a one-step binary tree for an asset. Since they are blind to risk they do not demand any compensation for it. U −D So the risk neutral probability q can also be interpreted as the probability of an up move in a risk neutral world. X − SD} = max{0. Yet another description of q that emerges from this calculation is that it is the probability that makes today’s spot price equal to the present value of the expected future payoﬀ. × 0. X − SU} = max{0. e−rT qPu + (1 − q)Pd 1 = max{0. A little later. if we change X to 105. over a time T . We observed earlier that the premium turns out to be the present value of the expected future payoﬀs.18 Mathematical Sciences Foundation: Course in Mathematical Finance We have the ﬁnal payoﬀs ∗ Pu = max{0. Let the up move have probability p. then the expected value of any asset will grow at the risk-free rate.05 = 2. The expected ﬁnal value of the asset is E[ST ] = pSU + (1 − p)SD. . 2 6 Risk-Neutral Valuation Let us take another look at the structure of the BOPM formulas for European call premiums. Further insight into q comes by considering risk neutral investors. it is best to not exercise early as that has a zero payoﬀ. the payoﬀ from exercising early is superior. Then we have E[ST ] = erT S =⇒ pSU + (1 − p)SD = erT S =⇒ p = erT − D = q. calculated using the risk-neutral probability q. On the other hand.

2 We compare with the value of the corresponding futures to get: C ≥ max{0. S − I − Xe−rT } C ≥ max{0. Unit 3: BOPM 19 Our results for European options extend immediately to any derivative whose ﬁnal payoﬀ depends only on the ﬁnal spot price of the underlying asset. and hence the initial value of the futures is given by n V = e−rT k=0 n n k q (1 − q)n−k SU k D n−k − X k n (qU)k ((1 − q)D)n−k − X k = e−rT S k=0 = e −rT S(qU + (1 − q)D)n − X = S − Xe−rT = e−rT SerT − X Exercise 6.1 P P ≥ max{0.Finance II. The payoﬀs at the end of an n-step binomial tree are SU k D n−k − X. we can re-derive the formula for the value of a futures contract. So the lower bound can be improved to P ≥ max{0. Xe−rT − S + I} −rT −qT (Income has present value I) (Income has continuous dividend yield q) − Xe −rT } (Income has present value I) ≥ max{0.1 Consider a contract which will pay you the square of the price of the underlying asset at a future time T . What is the correct price for this contract? A Solutions to Exercises Exercise 1. X − S} . Xe − Se −qT } (Income has continuous dividend yield q) Exercise 2. As an instance of this general approach. there is a payoﬀ of X − S > Xe−rT − S. We shall call such a derivative a European derivative. The extension of the BOPM formula to such a derivative is automatic since our calculations of European options premiums are independent of the formula for the ﬁnal payoﬀs. Se Exercise 2.2 If an American put is exercised at t = 0.

X − SU k D n−k } = SU k D n−k − X Substitute this in the n-step BOPM formula for C − P : n C −P = e−rT −e k=0 n −rT k=0 n k=0 n k q (1 − q)n−k max{0. max{0. Exercise 3. X − SU k D n−k } k n k q (1 − q)n−k SU k D n−k − X k n (qU )k ((1 − q)D)n−k − X k = S − Xe−rT = e−rT = e = e −rT −rT n S k=0 = e−rT SerT − X [S(qU + (1 − q)D)n − X] Exercise 6. But PutCall Parity says put and call prices move together — the only resolution is that the prices must be independent of the expected future asset price. SU k D n−k − X} k n k q (1 − q)n−k max{0. Exercise 4. SU k D n−k − X} − max{0.2 The same reasoning would suggest put prices would fall.1 Create the following portfolios at time t = 0: Portfolio A: 1 put and 1 share. Portfolio B: 1 call and Xe−rT cash. max{0.1 An n-step BOPM gives the value of the contract as n Vn = e −rT k=0 2 −rT n k q (1 − q)n−k S 2 U 2k D 2(n−k) k = S e = S 2 e−rT [erT /n (U + D) − 1]n [qU 2 + (1 − q)D 2 ]n . x} − max{0. −x} = x Therefore.4 Note that for any number x.20 Mathematical Sciences Foundation: Course in Mathematical Finance The upper bound similarly changes to P ≤ X. Exercise 3.

and then let n → ∞. A hint: substitute the power series expansions and consider the ﬁrst couple of terms. we obtain the 2 )T V = S 2 e(r+σ This limit takes some eﬀort to calculate.Finance II. o . Unit 3: BOPM If we take U = eσ value √ T /n 21 √ T /n and D = e−σ . Using the log function also helps. It is also possible to attack the problem via L’Hˆpital’s Rule.

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