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BinomialModel 1period PDF
BinomialModel 1period PDF
M. Haugh G. Iyengar
Department of Industrial Engineering and Operations Research
Columbia University
A Brief Overview of Option Pricing
2
Stock Price Dynamics in the Binomial Model
122.5
114.49
PPP
107 P PP107
PP
100
PP
P100
PP P PP
P 93.46
PP PP 93.46
PP P
PP 87.34
PP
PP
PP 81.63
PP
t=0 t=1 t=2 t=3
3
Some Questions
4
The St. Petersberg Paradox
But would you pay an infinite amount of money to play this game?
- clear then that (1) does not give correct option price.
5
The St. Petersberg Paradox
So maybe just need to figure out appropriate utility function and use it to
compute option price
maybe, but whos utility function?
in fact well see theres a much simpler way.
6
Financial Engineering & Risk Management
The 1-Period Binomial Model
M. Haugh G. Iyengar
Department of Industrial Engineering and Operations Research
Columbia University
The 1-Period Binomial Model
a
p 107 = uS0
S0 = 100
ah
hhhh
hhh
1p
hh ha 93.46 = dS0
t=0 t=1
2
The 1-Period Binomial Model
Questions:
3
Type A and Type B Arbitrage
Earlier definitions of weak and strong arbitrage applied in a deterministic world.
Need more general definitions when we introduce randomness.
t=0 t=1
Will soon see other direction, i.e. if d < R < u, then there can be no-arbitrage.
5
Financial Engineering & Risk Management
Option Pricing in the 1-Period Binomial Model
M. Haugh G. Iyengar
Department of Industrial Engineering and Operations Research
Columbia University
Option Pricing in the 1-Period Binomial Model
a
p 107
S0 = 100
ah
hhhh
hhh
1p
hh ha 93.46
t=0 t=1
2
The Replicating Portfolio
107x + 1.01y = 5
93.46x + 1.01y = 0
The solution is
x = 0.3693
y = 34.1708
So option price does not directly depend on buyers (or sellers) utility
function.
4
Derivative Security Pricing
C1 (S1 )
a
p
uS0 Cu
ah
S0 hhh hhh
1p
hhha
dS0 Cd
t=0 t=1
uS0 x + Ry = Cu
dS0 x + Ry = Cd
5
Derivative Security Pricing
Obtain
1 Rd uR
C0 = Cu + Cd
R ud ud
1
= [qCu + (1 q)Cd ]
R
1 Q
= E [C1 ]. (2)
R 0
Note that if there is no-arbitrage then q > 0 and 1 q > 0
- we call (2) risk-neutral pricing
- and (q, 1 q) are the risk-neutral probabilities.
So we now know how to price any derivative security in this 1-period model.
Can also answer earlier question: How does the option price depend on p?
- but is the answer crazy?!
6
Whats Going On?
Stock ABC a
p = .99 110
S0 = 100
a hh
h
hhhh
hha 90
1 p = .01
t=0 t=1
Stock XYZ
p = .01 a 110
S0 = 100
ahh
hh
ha
hhhh
1 p = .99 90
t=0 t=1
Question: What is the price of a call option on ABC with strike K = $100?
Question: What is the price of a call option on XYZ with strike K = $100?
7