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CHAPTER 26: THE BINOMIAL OPTION PRICING MODEL*

Current version: July 18, 2005


Chapter contents
Overview..............................................................................................................................2
26.1. The binomial pricing model.......................................................................................6
26.2. What can you learn from the binomial model?........................................................11
26.3. Multi-period binomial model...................................................................................14
26.4. Advanced topic: Using the binomial model to price an American put...................19
Conclusion .........................................................................................................................24
Exercises ............................................................................................................................25

This is a preliminary draft of a chapter of Principles of Finance with Excel. 2001 2005 Simon Benninga

(benninga@wharton.upenn.edu ).

PFE Chapter 26, Binomial option pricing

page 1

Overview
In Chapter 25 we discussed the Black-Scholes formula, the most common method for
pricing options. In this chapter we discuss the other major technique for determining option
prices, the binomial option pricing model. This model gives some insights into how to price an
option, and its also used widely (though not as widely as the Black-Scholes equation).
The basis of the binomial model is a very simple description of stock price uncertainty.
Heres an example: Suppose the current stock price of MicroDigits (MD) is $100. What can
you say about the MD stock price one year from now? The binomial model assumes that the
price of the stock in one year will either go up by a certain percentage or down by a certain
percentage. Heres an example:
A

BINOMIAL MODEL FOR MICRODIGITS


(MD) STOCK PRICE

1
2 Up
3 Down
4
5 MD stock
6
7
8
9

10
11
12
13
14
15

16

30%
-10%

price one year from now


130

<-- =100*(1+B2)

90

<-- =A7*(1+B3)

100

Date 0
today

Date 1
one year
from now

MD stock price returns


0.3

Date 0
today

<-- =C6/A7-1

-0.1
<-- =C8/A7-1
Date 1
one year
from now

PFE Chapter 26, Binomial option pricing

page 2

In the example above the MD stock price will either go up by 30% or down by 10% one
year from today. This means that the return on the stock will be either 30% or -10% (cells C13
and C15).
It is difficult to believe that such a simple description of stock price uncertainty could be
useful. However, if we extend the model to more periods, it turns out that the binomial model
can describe a wide range of stock price behaviors. In the example below we assume that the
price of MD stock goes up in each of the next two years by 30% or goes down by 10%. This
means that there are three possible outcomes for the stock price at Date 2: It can be either $169,
$117, or $81.
A

TWO-PERIOD BINOMIAL MODEL FOR MICRODIGITS (MD)


STOCK PRICE

1
2 Up
3 Down
4
5
6
7
8
9

10

30%
-10%
169

<-- =C6*(1+B2)

117

<-- =C6*(1+B3)

81
Date 2
two years
from now

<-- =C8*(1+B3)

130
100
90

Date 0
today

Date 1
one year
from now

If we extend the model to more periods, well get a wide range of possible prices and
returns. In the spreadsheet below we look at stock prices after 10 periods:

PFE Chapter 26, Binomial option pricing

page 3

MULTIPERIOD BINOMIAL MODEL FOR MICRODIGITS (MD) STOCK PRICE

1
2 Up
3 Down
4
5 Date
0
6
7
8
9
10
11
12
13
14
15
16
17
100.00
18
19
20
21
22
23
24
25
26
27

30%
-10%

10
1378.58

1060.45
815.73
627.49
482.68
371.29
285.61
219.70
169.00
130.00
117.00
117.00

334.16

197.73
152.10

81.00

270.67

160.16

94.77

187.39

110.88

65.61

219.24
168.65

129.73
99.79

76.76
59.05

316.69
243.61

144.15

85.29

457.44
351.87

208.21

123.20

72.90

390.97

231.34

136.89

660.74
508.26

300.75

177.96

105.30

564.74
434.41

257.05

954.40
734.16

151.78
116.76

89.81
69.09

53.14

105.08
80.83

62.18
47.83

72.75
55.96

43.05

50.36
38.74
34.87

If you plot the stock return and the probabilities of the returns after 10 years, you get a
graph such as the one below.1

The mathematics required to produce such a graph are too much for this book. For further details see my book

Financial Modeling, MIT Press (2nd edition, 2000).

PFE Chapter 26, Binomial option pricing

page 4

0.25

0.2

If the annual "up" return is 30% and the annual


"down" return is -10%, then after 10 periods, the
probability of a return of 357% is 11.72%.

Probability

0.15

The probability of a return of -50% is 1%.

0.1

0.05

0
-100%

0%

100%

200%

300%

400%

500%

600%

700%

800%

900%

1000%

1100%

1200%

1300%

Return

A pedagogical note
Most finance books first discuss the binomial option model and then discuss BlackScholes. Their reasoning is that this order is logical because in principle the Black-Scholes
pricing formula can be derived from the binomial model. In this book weve reversed the order,
because we despair of telling you exactly how Black-Scholes is derived from the binomial.
Instead, weve treated the two models as entirely different topics with different pedagogical
goals: Black-Scholes is the most commonly used option pricing model; as a finance person you
should be familiar with this model and understand how to manipulate it (notice that we havent
said that you need to understand it!). The binomial model is more educational but less useful (at
least on the level of this book): It gives some insights into how options are priced through a

PFE Chapter 26, Binomial option pricing

page 5

process of replication. It can also be used to understand topics such as the pricing of American
options and real options.
One of the uses we show for the binomial option pricing model is the use of the model to
price American options (section 26.4). These options cannot be priced using the Black-Scholes
formula, which prices only European options. In an advanced options course you will learn to
use the binomial option pricing model to price other, more complicated options.

Finance concepts in this chapter

Binomial model

Replicating portfolio

Excel functions used

Max

26.1. The binomial pricing model


To illustrate the use of the binomial model, we start with the following very simple
example:

Youre trying to calculate the value of a call option on ABC stock. The option
expires in one year and has an exercise price of $110.

PFE Chapter 26, Binomial option pricing

page 6

ABC stock sells today for $100. A wise person has informed you that in one year, the
price of the stock will either be $130 or $90.2 We will refer to these possibilities as
the up and the down states.

The one-year interest rate is 6%. You can borrow or lend at this rate.

Heres a spreadsheet picture which incorporates all this information (the spreadsheet also shows
the payoffs on a put written on ABC stockwell get to that in a moment):
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22

PRICING OPTIONS ON ABC STOCK--THE BINOMIAL MODEL


Up
Down

30%
-10%

Initial stock price


Interest rate
Exercise price

100
6%
110

ABC's stock price


in the "up" state

ABC's stock price

Bond price
130

<-- =$B$11*(1+B2)

100

1.06

<-- =$G$12*(1+$B$7)

1.06

<-- =$G$12*(1+$B$7)

1
90

ABC's stock price


in the "down" state

<-- =$B$11*(1+B3)
Call payoff in
the "up" state

Call option payoffs


20

Put option payoffs

<-- =MAX(D10-$B$7,0)

???

<-- =MAX($B$7-D10,0)

20

<-- =MAX($B$7-D12,0)

???
0

<-- =MAX(D12-$B$7,0)
Call payoff in the
"down" state

Were going to price the call option by showing that there is a combination of the bonds
and stocks which gives exactly the same payoffs as the call option. To show this, we use some
basic high school algebra: Suppose we buy a portfolio of A shares of the stock and buy B bonds.
Then the payoff of the portfolio in the up state is 130 A + 1.06 B and the payoff of the portfolio
in the down state is 90 A + 1.06 B . Now lets find A and B so that these two payoffs equal the
call option payoffs:

This wise person forgot to tell you the probabilities attached to these 2 events, but it turns out not to matter.

Surprised? You should be. But read on.

PFE Chapter 26, Binomial option pricing

page 7

130 A + 1.06 B = 20
90 A + 1.06 B = 0

This system of equations solves to give

130 A + 1.06 B = 20
90 A + 1.06 B = 0
20 0
0 90 A 90*0.5
A=
= 0.5, B =
=
= 42.4528
130 90
1.06
1.06
So now we know that buying half a share of ABC (cost: $50) and borrowing $42.4528
will give you payoffs in one year which are exactly the same as the payoffs of the call option.
The expenditure on this portfolio of {buy share, borrow $42.4528} should be the same as the
expenditure on the call option. Thus the call options price should be $7.5472:
call option price = 0.5*$100

.


$42.4528


= 7.5472

the cost of the


stock in the
"replicating
portfolio"

the financing
provided by
borrowing in the
"replicating
portfolio"

the market price


of the call
option

The Replicating Portfolio


The portfolio we derived aboveA = 0.5 shares and B = -$42.4528 borrowedgives the
same payoffs as the call option. For this reason it is often called the replicating portfolio.

Whats going on?market efficiency at work

Option pricing in the binomial model is a wonderful example of the first two principles of
efficient markets discussed in Chapter 17. The first principle (Competitive markets have a
single price for a single good) implies that the combination of the stock + borrowing (which in
terms of payoffs has exactly the payoffs of the call option) should be priced like the call option.
The second principle, price additivity (The price of a bundle of securities should be the sum of

PFE Chapter 26, Binomial option pricing

page 8

the prices of each of the securities) is also illustrated herethe price of the call option is the
cost of the stock ($45) minus the borrowing to finance this cost.
For option pricing theorists this method of pricing options is an example of arbitrage
the principle that if you can construct an assets payoffs in two ways, each of these ways should
have the same market value (which is, of course, Chapter 17s first principle of efficiency).
Summing it all up:
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26

PRICING OPTIONS ON ABC STOCK--THE BINOMIAL MODEL


Up
Down
Initial stock price
Interest rate
Exercise price

30%
-10%
100
6%
110

ABC's stock price


in the "up" state

ABC's stock price

Bond price
130

<-- =$B$11*(1+B2)

100

1.06

<-- =$G$12*(1+$B$7)

1.06

<-- =$G$12*(1+$B$7)

1
90

ABC's stock price


in the "down" state

<-- =$B$11*(1+B3)
Call payoff in
the "up" state

Call option payoffs


20

Put option payoffs

<-- =MAX(D10-$B$7,0)

???

<-- =MAX($B$7-D10,0)

20

<-- =MAX($B$7-D12,0)

???
0

<-- =MAX(D12-$B$7,0)
Call payoff in the
"down" state

The call replicating portfolio


Stock, A
0.5000 <-- =(D17-D19)/(D10-D12)
Bonds, B
-42.4528 <-- =(D19-D12*B24)/(1+B6)
Call price
7.5472 <-- =B24*B5+B25

Using the binomial model to price a put on ABC stock

We now use the binomial model to price a put on ABC with an exercise price of 110.
The put payoffs are shown above:

PFE Chapter 26, Binomial option pricing

page 9

G
H
14
15
16 Put option payoffs
17
18
???
19
20
21
22

J
Put payoff in the
"up" state

<-- =MAX($B$7-D10,0)

20

<-- =MAX($B$7-D12,0)
Put payoff in the
"down" state

The replicating portfolio is:


130 A + 1.06 B = 0
90 A + 1.06 B = 20

These equations solve to give:


A=

20
130 A 130 * ( 0.5)
= 0.5, B =
=
= 61.3208
130 90
1.06
1.06
The solution to the replicating portfolio indicates that short selling A = -0.5 shares and

investing in B = $61.3208 bonds gives the same payoffs as the put option. This means that the
price of the put is $11.3208:
put option price =
0.5*$100




+ $61.3208


= 11.3208

cash provided by
the short sale of
stock in the
"replicating
portfolio"

cash used to buy


bonds in the
"replicating
portfolio"

the market price


of the put
option

Put-call parityanother way of pricing the put

In Chapter 24 we learned the put-call parity principle:


Put price + Stock price = Call price + PV ( Exercise price )

Applying this principle in our problem, we get:

PFE Chapter 26, Binomial option pricing

page 10

Put price = Call price + PV ( Exercise price ) Stock price


= 7.5472 +

110
100 = 11.3208
1.06

Heres the whole spreadsheet, one more time:


A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37

PRICING OPTIONS ON ABC STOCK--THE BINOMIAL MODEL


Up
Down
Initial stock price
Interest rate
Exercise price

30%
-10%
100
6%
110

ABC's stock price


in the "up" state

ABC's stock price

Bond price
130

<-- =$B$11*(1+B2)

100

1.06

<-- =$G$12*(1+$B$7)

1.06

<-- =$G$12*(1+$B$7)

1
90

<-- =$B$11*(1+B3)

ABC's stock price


in the "down" state
Call option payoffs

Put payoff in the


"up" state

Put option payoffs


20

<-- =MAX(D10-$B$7,0)

???

<-- =MAX($B$7-D10,0)

20

<-- =MAX($B$7-D12,0)

???
0

<-- =MAX(D12-$B$7,0)

Put payoff in the


"down" state
The call replicating portfolio
Stock, A
0.5000 <-- =(D17-D19)/(D10-D12)
Bonds, B
-42.4528 <-- =(D19-D12*B24)/(1+B6)
Call price
7.5472 <-- =B24*B5+B25
The put replicating portfolio
Stock, A
-0.5000 <-- =(I17-I19)/(D10-D12)
Bonds, B
61.3208 <-- =(I17-D10*B29)/(1+B6)
Call price
11.3208 <-- =B29*B11+B30
Pricing the put by put-call parity
Call price
7.5472 <-- =B26
PV(exercise)
103.7736 <-- =B7/(1+B6)
Stock price
100 <-- =B5
Put price
11.3208 <-- =B34+B35-B36

26.2. What can you learn from the binomial model?


The binomial option pricing model is very instructive. It is an easy way to price options,
and it can also tell you something about more complicated option pricing model. Here are a few
lessons you can learn from the binomial model.

PFE Chapter 26, Binomial option pricing

page 11

A call looks like a portfolio composed of the purchase of a stock and the short sale of a
bond. The calls replicating portfolio is
A * SUp + B * (1 + r ) = Call payoffUp
A * S Down + B * (1 + r ) = Call payoff Down
where:
SUp and S Down are the stock prices in the "up" and "down" states
Call payoffUp and Call payoff Down are the call payoffs

In terms of the calls replicating portfolio, it turns out that A (the stock) is always positive
and B (the bond) is always negative. This indicates the purchase of a stock financed by
borrowing. In a sense the Black-Scholes formula has the same property:
BS call price = S * N ( d1 ) Xe rT N ( d 2 )


Purchase of
stock
(positive number)

Borrowing at
the risk free rate
( negative number )

A put looks like a portfolio composed of the short sale of a stock and the purchase of a
bond. The puts replicating portfolio is:
A * SUp + B * (1 + r ) = Put payoffUp
A * S Down + B * (1 + r ) = Put payoff Down
where:
SUp and S Down are the stock prices in the "up" and "down" states
Put payoffUp and Put payoff Down are the put payoffs

In terms of the puts replicating portfolio, it turns out that A (the stock) is always negative
and B (the bond) is always positive. This indicates the purchase of bonds financed by a
short sale of the stock. In a sense the Black-Scholes formula has the same property:
BS put price = S * N ( d1 ) + Xe rT N ( d 2 )


Short sale of
stock
(negative number)

PFE Chapter 26, Binomial option pricing

Investing at
the risk free rate
( positive number )

page 12

The probabilities of the up and the down states dont appear explicitly in the calculation
of the option price. To see what this means, look at the way we solved for the call option
price at the beginning of this chapter:
130 A + 1.06 B = 20
90 A + 1.06 B = 0
These equations solve to give:
20 0
0 90 A 90*0.5
A=
= 0.5, B =
=
= 42.4528
130 90
1.06
1.06
The resulting call option price:
call option price = 0.5*$100


$42.4528


= 7.5472

the cost of the


stock in the
"replicating
portfolio"

the financing
provided by
borrowing in the
"replicating
portfolio"

the market price


of the call
option

This calculation of the call option price when the option exercise price is $110 relies on 3
facts: i) The current stock price is $100, ii) The stock price next period is either 130 or
90, iii) The interest rate is 6%. Nowhere in this calculation have we made any reference
to the probabilities that the stock price will be $130 or $90.3

The binomial model is extendibleit can be used to price many options in a multiperiod
setting. In the next section we show a multi-period binomial model.

Of course you could quibble a bit and insist that the stock price today must incorporate these probabilities in some

sense, and youd be right. But even here you have to be carefulfor example, it would be wrong to say that the
stock price is the discounted expected future payoff of the stock. To explain this all would take us too far afield
suffice it to say that if investors are risk averse, theyll price the stock at below its expected future discounted
payoff. The amount of this discount depends on the risk aversion.

PFE Chapter 26, Binomial option pricing

page 13

26.3. Multi-period binomial model


The binomial model can be extended to multiple periods. Heres an example which
extends the previous example:
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24

THREE-DATE BINOMIAL OPTION PRICING


Up
Down

30%
-10%

Initial stock price


Interest rate
Exercise price

100
6%
110

Stock price

Bond price
169.00

1.1236

130
100

1.06
117.00

90
Date 0

Date 1

1.1236
1.06

81.00
Date 2

Date 0

Call option price

Date 1

1.1236
Date 2

Put option price


59.00

<-- =MAX(E10-$B$7,0)

0.00

???-1
???-0

7.00

<-- =MAX(E12-$B$7,0)

0.00
Date 2

<-- =MAX(E14-$B$7,0)

???-0

???-2
Date 0

Date 1

<-- =MAX($B$7-E10,0)

???-1
0.00

<-- =MAX($B$7-E12,0)

29.00
Date 2

<-- =MAX($B$7-E14,0)

???-2
Date 0

Date 1

In this example, the stock price goes up by 30% or down by 10% in each period. Starting
with a stock price of $100 at Date 0, the stock price at Date 1 will be either $130 or $90, and the
stock price at Date 2 will be either $169, $117, or $81.

$169: This happens if it goes up twicethat is: 169 = 100* (1.30 )(1.30 )

$117: This happens if the stock price goes up once and down oncethat is:
117 = 100* (1.30 ) * ( 0.90 ) . Notice that it doesnt matter if the stock price goes up first

and then down or the reverse.

$81:

This happens if the stock price goes down twicethat is 81 = 100* ( 0.90 )( 0.90 ) .

In each period the risk-free interest rate is 6%, so that $1 invested in the bond will grow to
$1.1236 at date 2.

PFE Chapter 26, Binomial option pricing

page 14

The call options terminal payoffs

At the end of the second period, the options payoffs are given by
Max (169 110,0 ) = 59

Max ( stock price at date 2 110,0 ) = Max (117 110,0 ) = 7


Max ( 81 110,0 ) = 0

We now have to value the option. We proceed by doing 3 valuationsthese are labeled in the
diagram as ???-1, ???-2, and ???-0. The put option has the same labelswell figure out
in a while how to price these.

Determining ???-1 for the call

We proceed as we did for the one-period binomial option pricing model. Setting up the
one-period stock and bond prices and option payoffs, we get:
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41

A
B
Finding ???-1 for the call

Stock price

Bond price
169.00

130

1.1236
1.06

117.00

1.1236

Call option price


59.00
???-1
7.00
The call replicating portfolio
Stock, A
1.0000 <-- =(D34-D36)/(D29-D31)
Bonds, B
-97.8996 <-- =(D36-B39*D31)/H29
Call price
26.2264 <-- =B39*B30+B40*F30

Setting up the equations (we use A to denote the number of shares and B to denote the bonds in
the replicating portfolio):

PFE Chapter 26, Binomial option pricing

page 15

169 A + 1.1236 B = 59
117 A + 1.1236 B = 7
Solution:
59-7
=1
169-117
7 117 * A
B=
= 97.8996
1.1236

A=

Call option price = 130* A + 1.06* B = 26.2264

These calculations are done in cells B39:B41.

Determining ???-2 for the call

Again we proceed as we did for the one-period binomial option pricing model. Setting
up the one-period stock and bond prices and option payoffs, we get:
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59

A
B
Finding ???-2 for the call

Stock price

Bond price
117.00

90

1.1236
1.06

81.00

1.1236

Call option price


7.00
???-2
0.00
The call replicating portfolio
Stock, A
0.1944 <-- =(D52-D54)/(D47-D49)
Bonds, B
-14.0174 <-- =(D54-B57*D49)/H47
Call price
2.6415 <-- =B57*B48+B58*F48

Determining ???-0 for the call

Once more we set up a simple binomial model, but this time we use the two values
derived abovethe prices of the call option at date 1.

PFE Chapter 26, Binomial option pricing

page 16

62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77

A
B
Finding ???-0 for the call

Stock price

Bond price
130.00

1.0600

100

1
90.00

1.0600

Call option price


26.2264
???-0
2.6415
The call replicating portfolio
Stock, A
0.5896 <-- =(D70-D72)/(D65-D67)
Bonds, B
-47.5703 <-- =(D72-B75*D67)/H65
Call price
11.3919 <-- =B75*B66+B76*F66

The resultweve calculated the option price today as $11.3919.4

Pricing the putthe long way

As you can see from the diagram, the put has date 2 payoffs of:
G
H
18 Put option price
19
20
21
???-0
22
23
24 Date 0

0.00

<-- =MAX($B$7-E10,0)

0.00

<-- =MAX($B$7-E12,0)

29.00
Date 2

<-- =MAX($B$7-E14,0)

???-1
???-2
Date 1

We can use the same logic (and even the same equations) to price the put. The results,
shown below with no explanations) show that the put price at date 0 is 9.2916.

You probably suspect that theres a more efficient way to do this, and youre right. A good starting place is

Financial Modeling, Chapter 14.

PFE Chapter 26, Binomial option pricing

page 17

A
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132

PRICING THE PUT


Finding ???-1 for the put
Stock price

Bond price
169.00

130

1.1236
1.06

117.00

1.1236

Put option price


0.00
???-1
0.00
The put replicating portfolio
Stock, A
0.0000 <-- =(D89-D91)/(D84-D86)
Bonds, B
0.0000 <-- =(D91-B94*D86)/H84
Put price
0.0000 <-- =B94*B85+B95*F85

There's actually no need to do any


calculations for ???-1: The price
???-1 is the value of a security
which has zero payoffs one period
hence. By any logic this price
should be zero.

Finding ???-2 for the put


Stock price

Bond price
117.00

90

1.1236
1.06

81.00

1.1236

Put option price


0.00
???-2
29.00
The put replicating portfolio
Stock, A
-0.8056 <-- =(D107-D109)/(D102-D104)
Bonds, B
83.8822 <-- =(D109-B112*D104)/H102
Put price
16.4151 <-- =B112*B103+B113*F103

Finding ???-0 for the put


Stock price

Bond price
130.00

100

1.0600
1

90.00

1.0600

Put option price


0.0000
???-0
16.4151
The put replicating portfolio
Stock, A
-0.4104 <-- =(D125-D127)/(D120-D122)
Bonds, B
50.3293 <-- =(D127-B130*D122)/H120
Put price
9.2916 <-- =B130*B121+B131*F121

PFE Chapter 26, Binomial option pricing

page 18

Pricing the put using put-call parity

We can also use put-call parity to price the put. As discussed in Section 24.3 put-call
parity says:
Put price + Stock price = Call price + PV ( Exercise price )

Applying this principle to the 2-date option, we get:

Put price = Call price + PV ( Exercise price ) Stock price


= 11.3919 +

135
136
137
138
139
140

110

(1.06 )

100 = 9.2916

A
B
C
D
E
Pricing the put with put-call parity
Initial stock price
100
Interest rate
6%
Exercise price
110
Call price
11.3919
Put price
9.2916 <-- =B139+B138/(1+B137)^2-B136

26.4. Advanced topic: Using the binomial model to price an American put
The binomial model is cute and easy to understand. But why do we need it? The answer
is complex and mostly beyond the scope of this book:

Whereas the Black-Scholes formula prices only European options, the binomial model
can be used to price American options. This use of the binomial model is illustrated in
the next sub-section.

Properly implemented, the binomial model can help us prove the Black-Scholes formula.
This use of the binomial model is too advanced for this book.

PFE Chapter 26, Binomial option pricing

page 19

The binomial model can be used to price more complex options than those priced with
Black-Scholes, which prices only European options.

For example, we can use the

binomial model to price options where the exercise price changes over time, or where the
interest rate varies.

We can also use the binomial model to price options where the up and the down
movements of the stock price vary over time. Many finance people believe, for example,
that the volatility of the stock price return varies with the price itselfthat the percentage
up and the down movements for a stock are larger when the stock price is small.
This can be handled by the binomial model, but not by Black-Scholes.

PFE Chapter 26, Binomial option pricing

page 20

Weird Options and the Binomial Model


The binomial model is especially useful in determining the price of weird options.
Here are two examples of such options.
An Asian option is an option whose payoff is determined by the average price of the
stock over a certain period before the options maturity. One specification of an Asian call
option might be:

On 29 January 2005 you buy an Asian call option on IBM with a maturity of one year.
The options payoff on 29 January 2006 is the difference between the average daily
closing IBM stock price in the 30 days preceding the options maturity and the options
exercise price X = $120. This option cannot be priced using the Black-Scholes model,
but it can be priced using the binomial model.
A barrier option is an option whose payoff depends on whether the stock price reaches a

certain point during the life of the option. Heres an example:

On 29 January 2005 you buy a one-year knock-in barrier option on IBM, which is
currently selling at $93. The option specifies that you have the right to buy a share of
IBM on 29 January 2006, provided that at some point during the year IBMs stock price
exceeds $120 (this is the knock-in barrier. If the price of IBM during the coming year
does not exceed $120, your option is worthless. Barrier options cannot be priced using
the Black-Scholes model, but they can be priced using the binomial model.
There are many more of these weird options.

A good place to start for some

background is http://www.riskglossary.com .

PFE Chapter 26, Binomial option pricing

page 21

Using the binomial model to price American options

To illustrate one more-sophisticated use of the binomial model, well show you how it
can be used to price an American option. Recall that American options can be exercised early.
We go back to our 2-date example and focus on the put price (highlighted):
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21

THREE-DATE BINOMIAL OPTION PRICING--American options


Up
Down

30%
-10%

Initial stock price


Interest rate
Exercise price

100
6%
110

Stock price

Bond price
169.00

1.1236

130

1.06

100

117.00

1.1236

90

1.06
81.00

1.1236

Call option price

Put option price


59.00

<-- =MAX(E10-$B$7,0)

???-1

0.00

<-- =MAX($B$7-E10,0)

0.00

<-- =MAX($B$7-E12,0)

29.00

<-- =MAX($B$7-E14,0)

???-1

???-0

7.00

<-- =MAX(E12-$B$7,0)

???-0

???-2

???-2
0.00

<-- =MAX(E14-$B$7,0)

Well price the put just as we did the call in the previous section. However, this time we
assume that the put is an American putmeaning that it can be exercised early.
We start by pricing the put at the up-state of date 1 (this is marked ???-1 in the
spreadsheet. This is actually fairly simple: at ???-1 the put owner has future payoffs of zero, no
matter what happens. This means that the put should be worth zero, and thats exactly what the
spreadsheet tells us:
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39

A
Finding ???-1 for the put

Stock price

Bond price
169.00

130

1.1236
1.06

117.00
Put option price
0.00
???-1
0.00
The put replicating portfolio
Stock, A
Bonds, B
Put price ???-1

1.1236
There's actually no need to do
any calculations for ???-1: The
price ???-1 is the value of a
security which has zero payoffs
one period hence. By any logic
this price should be zero.

0.0000 <-- =(D32-D34)/(D27-D29)


0.0000 <-- =(D34-B37*D29)/H27
0.0000 <-- =B37*B28+B38*F28

PFE Chapter 26, Binomial option pricing

page 22

At ???-2 the situation is more complicated. The put has a future payoff which is positive.
We can use the binomial model to solve for the put price:
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58

A
Finding ???-2 for the put

Stock price

Bond price
117.00

1.1236

90

1.06
81.00

1.1236

Put option price


0.00
???-2
29.00
The put replicating portfolio
Stock, A
Bonds, B
European put price ???-2
American put price ???-2

-0.8056
83.8822
16.4151
20.0000

<-- =(D50-D52)/(D45-D47)
<-- =(D52-B55*D47)/H45
<-- =B55*B46+B56*F46
<-- =MAX(B7-B46,B55*B46+B56*F46)

But now the early-exercise feature of the put comes in (rememberits an American
put). The put value of $16.4151 (cell B57 above) is the value of a put which has payoffs only
next period. Instead of waiting until next period, we can exercise the put today: The stock price
is $90 and the put exercise is $110, which means we can collect $20 immediately if we earlyexercise the put. So the actual put valuegiven the early-exercise featureis $20 and not
$16.4151 (cell B58):
Using this value of $20, we can price the put at date 0:
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75

A
Finding ???-0

Stock price

Bond price
130.00

100

1.0600
1

90.00

1.0600

Put option price


0.0000
???-0
20.0000
The put replicating portfolio
Stock, A
-0.5000 <-- =(D68-D70)/(D63-D65)
Bonds, B
61.3208 <-- =(D70-B73*D65)/H63
American put price ???-0
11.3208 <-- =MAX(B7-B64,B73*B64+B74*F64)

PFE Chapter 26, Binomial option pricing

page 23

In Section 26.3 we priced a European put with the same exercise price X = $110. There
we concluded (page000) that the value of the European put is $9.2916. When we reprice the put
as an American put, we see that its price is $11.3208, higher than the European put price. This
happens because we will want to early-exercise the put at ???-2.

Conclusion
The binomial option pricing model can be used to price options under more general
conditions than those which hold for the Black-Scholes model. This chapter has revealed only
the tip of this financial iceberg, showing you how to implement the model in a 1-date and 2-date
framework. Weve also indicated how the model can be used to price American options and
weird options such as Asian options or barrier options.

PFE Chapter 26, Binomial option pricing

page 24

Exercises
1. A stock selling for $25 today will, in one year, be worth either $35 or $20. If the interest rate
is 8%, what is the value today of a one-year call option on the stock with exercise price $30?
Use the simultaneous equation approach of section 14.1 to price the option.

2. In the exercise 1: Calculate the value today of a one-year put option on the stock with
exercise price $30. Show that put-call parity holds: That is, using your answer from this
problem and the previous problem, show that:
call price +

X
= stock price today + put price
1+ r

3. In a binomial model a put option is written on a stock selling today for $30. The exercise
price of the put option is 40. The put options payoffs are 20 and 5. The price of the put is
12.25. What is the riskless interest rate? Assume that the basic period is one year.

4. All reliable analysts agree that a share of ABC Corp., selling today for $50, will be priced at
either $65 or $45 one year from now. They further agree that the probabilities of these events
are 0.6 and 0.4 respectively. The market risk-free rate is 6%. What is the value of a call option
on ABC whose exercise price is $50 and which matures in one year?

5. A stock is currently selling for 60. The price of the stock at the end of the year is expected
either to increase by 25% or to decrease by 20%. The riskless interest rate is 5%. Calculate the

PFE Chapter 26, Binomial option pricing

page 25

price of a European put on the stock with exercise price 55. Use the binomial option pricing
model.

6. Fill in all the cells labeled ??? in the following spreadsheet:


THREE DATE BINOMIAL OPTION PRICING
Up
Down

35%
-5%

Initial stock price


Interest rate
Exercise price

40
25%
40

state prices
qu

???

qd

???

Stock price

Bond price
???

???

???
40

???
???

???

???
???

???

Call option price

???

European put option price


???

???

???
???

???
???

???

???

???

???
???

???

American put option


???
???
???

???
???
???

7. Consider the following 2-period binomial model, in which the annual interest rate is 9% and
in which the stock price goes up by 15% per period or down by 10%:
Stock price

Bond price
66.1250

1.1881

57.50
50

1.09
51.7500

45.00

1.1881
1.09

40.5000

1.1881

a. Price a European call on the stock with exercise price 60.

PFE Chapter 26, Binomial option pricing

page 26

b. Price a European put on the stock with exercise price 60.


c. Price an American call on the stock with exercise price 60.
d. Price an American put on the stock with exercise price 60.

8. Consider the following 3-date binomial model:

In each period the stock price either goes up by 30% or decreases by 10%.

The one-period interest rate is 25%

Stock price

Bond price
50.70

1.5625

39.00
30

1.25
35.10

1.5625

27.00

1.25
24.30

1.5625

a. Consider a European call with X = 30 and T = 2. Fill in the blanks in the tree:
Call option price
???
???
???

???
???
???

b. Price a European put with X = 30 and T = 2.


c. Now consider an American put with X = 30 and T = 2. Fill in the blanks in the tree:
American put option price
???
???
???

???
???
???

9. A prominent securities firm recently introduced a new financial product. This product, called
The Best of Both Worlds (BOBOW for short), costs $10. It matures in 5 years, at which point

PFE Chapter 26, Binomial option pricing

page 27

it repays the investor the $10 cost plus 120% of any positive return in the S&P500 index. There
are no payments before maturity.
For example: If the S&P500 is currently at 1500, and if it is at 1800 in 5 years, a
BOBOW owner will receive back $12.40 = $10*[1 + 1.2*(1800/1500-1)]. If the S&P is at or
below 1500 in 5 years, the BOBOW owner will receive back $10.
Suppose that the annual interest rate on a 5 year, continuously compounded, purediscount bond is 6%. Suppose further that The S&P500 is currently at 1500 and that you believe
that in 5 years it will be at either 2500 or 1200. Use the binomial option pricing model to show
that BOBOWs are worth more than their current price of $10.

10. A call option is written on a stock whose current price is $50. The option has maturity of 2
years, and during this time the annual stock price is expected to increase by 25% or to decrease
by 10%. The annual interest rate is constant at 6%. The option is exercisable at date 1 at a
price of $55 and at date 2 for a price of $60. What is its value today? Will you ever exercise the
option early?

11. A stock is currently selling for 60. A Put option has maturity of 2 years, and during this
time the annual stock price is expected to increase by 30% or to decrease by 10%. The riskless
interest annual rate is 6%. The put option is currently selling for $9. Is the option more likely an
American or a European put option? Use the binomial option pricing model to determine.

12. A call option is written on a stock whose current price is $100. The option has maturity of 2
years, and during this time the annual stock price is expected to increase by 30% or to decrease

PFE Chapter 26, Binomial option pricing

page 28

by 10%. The annual interest rate is constant at 6%. The options exercise price is $110. Extend
the Binomial Option Pricing to incorporate a $3.00/share dividend that will be paid out in
period 2. In other words, all of the period 2 stock prices will be reduced by $3.00. Determine the
current prices of the call. Compare to the non-dividend case that is appears in Chapter 26.

13. A 2-years American put option is written on a stock whose current price is 42. You expect
that in each year the stock price either goes up by 10% or decreases by 5%. The one-period
interest rate is 5%. The options exercise price is 45.
Will you ever exercise the option early? Refer to Fact 6 of Chapter 21.

PFE Chapter 26, Binomial option pricing

page 29