Derivatives

•  Lectures #10-12:
•  Part V: Option pricing
»  Determinants of an Option’s Premium Part VI:
»  Black-Scholes formula
»  Intro to Binomial Trees & Risk Neutral Valuation
Valuing Options in Practice
•  Lectures #11-13:
•  Part VI: Valuing Options in Practice
»  Binomial Trees & Risk-Neutral Option Pricing
»  Black-Scholes extensions

Practical Binomial Option Pricing Binomial Option Pricing

•  Fundamentals •  Basic idea

•  What? Why? How? •  approximate the movements in an asset’s price
»  by discretizing the underlying’s price movements
•  Underlying Price Movements »  to simplify the pricing of derivatives on the asset
•  Binomial trees •  Realistic?
•  Option Pricing •  so far
»  3-month or 1-year intervals
•  1. no dividends •  in practice
•  2. continuous dividends »  divide option’s life span into 30+ periods (ideally: 100+)
•  3. discrete, known dividends »  yields 230 =1 billion+ possible price paths

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Binomial Trees Binomial Trees 2

•  Asset Price Movements •  Moves in time interval Δt (H7 Fig. 19.1; H8 Fig.20.1)
p Su
•  divide option life (t to T) into small intervals Δt
S ƒu
•  in each interval of time, assume asset price can
ƒ (1 –
move UP ⇑ p ) Sd
by a proportional amount u or
ƒd
•  Derivatives can be “risk-neutrally” priced
move DOWN ⇓ •  expected return of all securities = risk-free rate
•  discounting of all cash-flows is done at risk-free rate
by a proportional amount d
•  calls, puts, stocks, etc.
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 Tree Parameters Tree Parameters 2
•  What? •  1. Nondividend Paying Stock
•  p , u , & d
•  Situation
•  How? •  need to find u, p and d
•  tree must give correct values •  find 3 equations with 3 unknowns
•  for the mean & standard deviation »  mean, variance, simplification
•  of the stock price changes •  a. mean of the stock price:
•  in a risk-neutral world (why?) •  expected stock price: pSu + (1– p )Sd
•  Simplification •  risk-neutral value : S er Δt
•  assume that u = 1/ d •  hence (Eq. 20.1) : S er Δt = pSu + (1– p )Sd

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Tree Parameters 3 Tree Parameters 4

•  b. standard deviation of the stock price:
•  variance: •  a & b & c: approximate solution
pS 2u 2 + (1– p )S 2d 2 – S 2[pu + (1– p )d ]2 •  if Δt is small, then (Ch. 17, H6; Ch. 19, H7; Ch. 20, H8)
•  risk-neutral value:
S2 σ2Δt u = eσ Δt
(20.5)
•  hence: d=e −σ Δt
(20.6)
S2 σ2Δt
= pS 2u 2 + (1– p )S 2d 2 – S 2[pu + (1– p )d ]2 a−d
p= = risk-neutral probability (20.4)
•  c. simplification u−d
•  assume that u = 1/ d a = e r Δt = growth factor (20.7)

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Tree Parameters 5 Backwards Induction

•  Full (Recombining) Tree Su 4
Su 3
(Fig.19.2 or 20.2)
Su 2 •  Idea
Su 2 •  We know the value of the option
Su Su
»  at the final nodes
S •  Work back through the tree
S S
Sd Sd »  using risk-neutral valuation
-  to calculate the value of the option at each node
Sd 2
Sd 2 •  American vs. European options
Sd 3 •  American options
»  test for early exercise at each node (where appropriate)
Sd 4
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 Backward Induction 2 – Put Example Backward Induction 3 – Put Example
•  Option parameters •  Solution
S = 50; X = 50; T = 5 months •  parameters imply
•  Other data u = 1.1224; d = 0.8909;
annualized risk-free rate r = 10% a = 1.0084; p = 0.5076
underlying annual std. dev. σ = 40% •  in practice
•  Time parameters »  solve tree manually (Fig. H7-19.2 or H8 20.2)
»  or use software
T = 5 months = 5/12 = 0.4167;
-  example: DerivaGem (Fig. 19.3 or 20.3)


Δt = 1 month = 1/12 = 0.0833

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Backward Induction 4 – Put Example Tree Parameters 6

89.07
Fig. 20.3 0
79.35
70.70 0 70.70 •  2. Dividend Paying Stock (continuous time)
62.99 0 62.99 0
•  dividend yield
56.12 0.63 56.12 0 56.12
0 »  q (continuously compounded rate)
50 2.15 50 1.30 50
4.48 44.55 3.76 44.55 2.66 44.55 •  payout consequence
6.95 39.69 6.37 39.69 5.45 »  underlying price grows more slowly
10.35 35.36 10.31 35.36 -  as dividends are being paid out
14.64 31.50 14.64
•  risk-neutral valuation
18.50 28.07 »  must reflect lower growth rate of underlying price
21.93
t=0 t=0.0833 t=0.1667 t=0.25 t=0.333 t=0.4167
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Tree Parameters 7 Tree Parameters 8

•  Situation •  b. standard deviation of the stock price:
•  need to find u, p and d •  variance:
•  find 3 equations with 3 unknowns pS 2u 2 + (1– p )S 2d 2 – S 2[pu + (1– p )d ]2
»  mean, variance, simplification •  risk-neutral value:
S2 σ2Δt
•  a. mean of the stock price:
•  hence:
•  expected stock price: pSu + (1– p )Sd S2 σ2Δt
•  risk-neutral value : S e(r-q) Δt = pS 2u 2 + (1– p )S 2d 2 – S 2[pu + (1– p )d ]2
•  hence (Eq. 19.1 or 20.1): S e(r-q) Δt = pSu + (1– p )Sd
•  c. simplification
•  assume that u = 1/ d

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 Tree Parameters 9 Tree Parameters 10
•  Relevance of the continuous-payout case
•  a & b & c: approximate solution –  Analogy
•  if Δt is small, then (Ch. 20 in H8, Ch. 19 in H7)
•  treatment similar to Black-Scholes

u = eσ Δt
(20.5) –  Cases
•  stock index option
d = e −σ Δt
(20.6) »  q = dividend yield on the index

a−d •  foreign currency option

p= (20.4) »  q = foreign risk-free rate = r*
u−d
•  futures contracts option
a = e (r−q ) Δt (20.7) »  q = rf
-  why? ensures expected growth of F in a R-N world is 0
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Tree Parameters 11 Tree Parameters 12

•  Examples of the continuous-payout case

–  DerivaGem software
•  e.g., importance of dividends for early exercise
•  IBM is currently trading at S0 = $86.50
»  annualized interest rates are currently around r = 1.75%
»  the annual stock return volatility is about σ = 21%
»  strike X = $90: should you exercise an IBM call early?
-  IBM’s dividend yield is currently about q = 2.61%
-  P.22: American call; p.23: European call
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Tree Parameters 13 Tree Parameters 14

•  3. Dividend Paying Stock (yield known)

•  Problem
•  the dividend is paid once (or a few times)
•  during the life of the option
•  Solution
•  similar to case 2 (continuously paid dividends)
•  intuition
»  once the dividend has been paid
»  the tree recombines (Fig. 17.7 in H6, Fig. 19.7 in H7)

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 Tree Parameters 13 Tree Parameters 14
•  Ex-dividend date = τ (Figs. 19.8-9 or 20.7-8)
•  4. Dividend Paying Stock (value known)
•  tree step
•  Problem »  i=1,2,..,N
•  tree does not recombine »  where NΔt = T
•  Solution •  Uncertain component’s value at time iΔt
•  draw an initial tree (uncertain component) •  S* = S
»  for the stock price less the present value of the dividends »  when iΔt > τ
(i.e., ex-dividend)
•  create the final tree (add certain component) •  S* = S - D*exp[-r(τ - iΔt)]
»  by adding the present value of the dividends at each node
»  when iΔt ≤ τ
(i.e., cum-dividend)
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Tree Parameters 15 Tree Parameters 16

•  4. IBM, no div. •  4. June div.=56c

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Tree Parameters 17 Extensions

•  4. June div.=56c •  Control-variate techniques

•  why?
•  when? Black-Scholes is OK

•  Interest rates
•  in Black-Scholes, theoretical problem
•  here, simple solution (why?)
•  Extra lecture
•  interest rate derivatives
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 Control-Variate Technique Control-Variate Technique
for American Options for American Options 2
•  Use the same tree •  Use the same tree
•  to calculate the value of •  to calculate the value of
»  American option, fA = $1.63
»  American option, fA and corresp’ing European option, fE
»  and corresp’ing European option, fE = $1.50
•  Let fBS = Black-Scholes price of the same option.
»  price of the American option can then be adjusted •  Let fBS = B&S price of the same option = $1.52
»  to fA + fBS - fE »  price of the American option can then be adjusted
»  to fA + fBS - fE = $1.63 + (1.52-1.50) = $1.65
•  Underlying assumption
•  “tree-errors” are the same •  Underlying assumption
•  for European and American options •  “tree-errors” are the same
•  for European and American options
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Time-Varying Interest Rates

•  Allow for interest rates to vary over time

a−d
•  Before, p=
u−d
a = e r Δt

a (t ) − d
•  Now, p (t ) =
u−d
a (t ) = e r ( t ) Δt

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