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# Lecture 5: The Binomial Model

## Alan Holland aholland@4c.ucc.ie

University College Cork

Summary

## The Binomial Model

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The Binomial Model Introduction Pricing an Option in the Binomial Model Example Constructing a risk-free portfolio Valuing the option The Binomial Tree Distribution Valuing using backward induction Continuous-time limit Summary

## The Binomial Tree

Summary

Overview
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The Binomial Model Introduction Pricing an Option in the Binomial Model Example Constructing a risk-free portfolio Valuing the option The Binomial Tree Distribution Valuing using backward induction Continuous-time limit Summary

## The Binomial Tree

Summary

This lecture. . .

This lecture consists of A simple model for an asset price random walk, delta hedging, no arbitrage, the basics of the binomial method for valuing options, risk neutrality.

## The Binomial Tree

Summary

Introduction

The most accessible approach to option pricing is the binomial model. This model has the following features: basic arithmetic and no complicated stochastic calculus, ideas of hedging and no arbitrage are present, a simple algorithm for determining the correct value for an option.

## The Binomial Tree

Summary

Up or Down Movements

In the binomial model we assume that the asset, which initially has the value S, can, during a timestep t, either move up or down,
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## The Binomial Tree

Summary

Price movements

The three constants u, v and p are chosen to give the binomial walk the same drift and standard deviation as the asset we are trying to model.

## The Binomial Tree

Summary

Overview
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The Binomial Model Introduction Pricing an Option in the Binomial Model Example Constructing a risk-free portfolio Valuing the option The Binomial Tree Distribution Valuing using backward induction Continuous-time limit Summary

## The Binomial Tree

Summary

Example
Example Let u = 1.01, v = 0.99, p = 0.55. The current asset price S is 100 so there is a 55% chance that the stock price will next be 101 and a 45% chance it will be 99. What does next mean and how were these numbers chosen? Next means after a small timestep, say one day. So we will be looking at what happens from one day to the next. How we chose u, v and p is something we will come back to shortly.

## The Binomial Tree

Summary

Portfolio

Now let us assume that we hold a call option on this asset that is going to expire tomorrow (t = 1 day). This option has a strike of 100. Holding just the stock or the option is risky: Stock If the asset rises we have 101, a prot of 1, whereas if it falls we have 99, a loss of 1. Option If the asset rises to 101 we get a payoff of 1. If it falls to 99 we get no payoff, the asset expires out of the money.

Summary

## Constructing a risk-free portfolio

A portfolio

Let us sell short a quantity, , of the underlying asset so that now we have a portfolio consisting of a long option position and short stock position. Up If the asset rises to 101 we have a portfolio worth max(101 100, 0) ( 101) = 1 101 Down If the asset falls we have max(99 100, 0) ( 99) = 99 This portfolio is risky in the sense that there are two values that it can take, we dont know what the portfolio will be worth. Or is it in fact risky?

Summary

## Step 1: Construct a risk-free portfolio

Suppose we choose such that 1 101 = 99, i.e. = 1 , 2 then whether the asset rises or falls our portfolio has a value of: 1 101 = 99 = 99 . 2

There is no risk, we are guaranteed this amount of money irrespective of the behaviour of the underlying. This is hedging.

Summary

## Step 2: Apply no arbitrage rule

We are now half way to valuing this option today, one day before expiry. The second and nal step, is to say that if the portfolio has a guaranteed payoff then the return must be the same as the risk-free rate applied over the one day. If V is the option value today then our portfolios value is currently V 100, for some V to be found. The present value of the portfolio, discounting at an interest rate of r is 1 99 . 1 + r t 2

## The Binomial Tree

Summary

Step 2 contd.

This must be the same as the portfolio value today so 1 1 99 V (100) = V 100 = V 50 = r 2 1 + 252 2 . Put in the relevant r and calculate V from this, V = 50 1 99 r 1 + 252 2

. Simple. Note that Ive assumed 252 business days in one 1 year so that t = 252 . If r = 10% then V = 0.5196.

Summary

## So what does the value of an option depend upon?

The conclusion is that the option value depends on the interest rate, the payoff, the size of the up move, the size of the down move and the timestep. Probabilities are irrelevant! But it does not depend on the probability of the up move. p never came into the calculation. This is very counter-intuitive. Surely the value of an option depends on whether the asset is likely to go up or down. It turns out that this is not the case. We will expand on this idea further shortly, but rst lets do the same calculation in general.

Summary

## Generalized Binomial Model

First, we let the short timestep be t. We are going to give some expressions now for u, v and p and then see where they come from: u = 1 + t, v = 1 t, 1 t p= + . 2 2 We have introduced two new parameters here: the drift of the asset and the volatility. We shall look at the average change in asset price during the timestep t and the standard deviation.

Summary

## Average Asset Change

The expected asset price after one timestep t is puS + (1 p)vS = (1 + t)S. So the expected change in the asset is St. The expected return is t. This is something that is measurable given statistical information on the asset data.

Summary

## Standard Deviation of Asset Price Change

The variance in change in asset price is S 2 2 t, so the standard deviation of asset changes is S t The standard deviation of returns is t We can measure and statistically.

Summary

## Pricing the Option

The option value at the next timestep is determined by:
1 2

## constructing a risk-free portfolio, applying the principle of no arbitrage, V = 1 (p V + + (1 p )V ), r t

to get:
r t 2 .

where p =

1 2

Note that p is not the probability p of a rise in value, which was p = 1 + 2t . We call p the risk-neutral probability. 2 Observe that the risk-free interest plays two roles in option valuation. It is used once for discounting to give present value, and also as the drift rate in the asset price random walk.

Summary

## Where did p go?

What happened to the probability p and the drift rate ? Interpreting p (from the previous slide) as a probability, is the statement that the option value at any time is the present value of the expected value at any later time. That is because the up move value V + is multiplied by a probability and the down move value V is multiplied by one minus that probability.

## The Binomial Tree

Summary

Overview
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The Binomial Model Introduction Pricing an Option in the Binomial Model Example Constructing a risk-free portfolio Valuing the option The Binomial Tree Distribution Valuing using backward induction Continuous-time limit Summary

Summary

## The Binomial Tree

Single Step The binomial model allows the stock to move up or down a prescribed amount over the next timestep. If the stock starts out with value S then it will take either the value uS or vS after the next timestep. Multiple Steps After two timesteps the asset will be at either u 2 S, if there were two up moves, uvS, if an up was followed by a down or vice versa, or v 2 S, if there were two consecutive down moves. After three timesteps the asset can be at u 3 S, u 2 vS, etc. This random walk out can be extended all the way until expiry. The result is the binomial tree.

Summary

Binomial Tree

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Binomial Tree

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## Probability Density Function

The top and bottom branches of the tree at expiry can only be reached by one path each, either all up or all down moves. There will be several paths possible for each of the intermediate values at expiry. Therefore the intermediate values are more likely to be reached than the end values if one were doing a simulation. The binomial tree contains within it an approximation to the probability density function for the lognormal random walk.

Summary

## Asset price distribution

The probability of reaching a particular node in the binomial tree depends on the number of distinct paths to that node and the probabilities of the up and down moves. Since up and down moves are approximately equally likely and since there are more paths to the interior prices than to the two extremes we will nd that the probability distribution of future prices is roughly bell shaped.

Summary

Summary

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## Valuing back down the tree

We know V + and V at expiry, time T , because we know the option value as a function of the asset then, this is the payoff function. If we know the value of the option at expiry we can nd the option value at the time T t for all values of S on the tree.
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Knowing these values means that we can nd the option values one step further back in time. Thus we work our way back down the tree until we get to the root. This root is the current time and asset value, and thus we nd the option value today.

Summary

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## A European Put Example

The procedures described in this example can be used to price any derivative dependent on a stock whose price changes are binomial. Example Consider a two-year European put with a strike of \$52 on a stock whose current price is \$50. Let us suppose there are two timesteps in the one year, and in each timestep the stock can rise 20% or fall 20%, and r = 5%. Solution p = e0.051 0.8 = 0.6282 1.2 0.8

The possible nal stock prices are: \$72, \$48, and \$32.

Summary

## European Put Example contd.

Solution contd. In this example, fuu = 0, (the value of the option after two increases), fud = 4, and fdd = 20.

f = e20.051 (0.62822 0+20.6282.37184+0.37182 20) = 4.1 The value of the put is \$4.1923, we could get this gure from working back through the tree also.

Summary

## Valuing using backward induction

American Options
Work back through the tree from the end to the beginning, testing at each node to see if early exercise is optimal. The value of the option at the nal nodes is the same as that of the European option. At earlier nodes the value of the option is the greater of: 1 V = ert (p V + + (1 p )V ), 2 The payoff from early exercise.

Summary

## American Put Option contd.

American option valuation At the initial node A, the value of the option is e0.051 (0.6282 1.4147 + 0.3718 12.0) = 5.0894, and the payoff from early exercise is 2. In this case early exercise is not optimal

Summary

## Valuing using backward induction

Delta ()

Delta () is the ratio of the change in the price of the stock option to the change in the price of the underlying ( V ). S The value of varies from node to node. This is one of the Greeks that we will come back to in later lectures.

Summary

## Take the formula for valuing an option in the binomial model: V =

1 (p V + + (1 p )V ), r t

## The Binomial Tree

Summary

Towards Black-Scholes...

If we also let V = V (S, t), V + = V (uS, t + t) and V = V (vS, t + t), we can expand these expressions in Taylor series for small t and substitute for V , V + and V to get: V 1 2V V + 2S2 2 + r rV = 0 t 2 S S (1)

## The Binomial Tree

Summary

Summary

Summary A simple model for an asset price random walk, delta hedging, no arbitrage, the basics of the binomial model for valuing options, risk neutrality.