CORE: Advanced Techniques In Finance Monsoon 2019

Lecture 9: 11/02/2019
Lecturer: Dr. Rakesh Nigam Scribe: Praveen, Fouzul Abid, Anshul Gupta

9.1 The Binomial Asset Pricing Model

The binomial asset pricing model provides a powerful tool to understand arbitrage pricing
theory and probability theory. In this course, we shall use it for both these purposes.
In the binomial asset pricing model, we model stock prices in discrete time, assuming that
at each step, the stock price will change to one of two possible values. Let us begin with an
initial positive stock price S0 . There are two positive numbers, d and u, with

0<d<u

such that at the next period, the stock price will be either dS 0 or uS 0. Typically, we take
d and u to satisfy 0 < d < 1 < u, so change of the stock price from S0 to dS0 represents a
downward movement, and change of the stock price from S0 to uS0 represents an upward
movement. It is common to also have d = u1 , and this will be the case in many of our examples.

Of course, stock price movements are much more complicated than indicated by the
binomial asset pricing model. We consider this simple model for three reasons. First of all,
within this model the concept of arbitrage pricing and its relation to risk-neutral pricing is
clearly illuminated. Secondly, the model is used in practice because with a sufficient number of
steps, it provides a good, computationally tractable approximation to continuous-time models.
Thirdly, within the binomial model we can develop the theory of conditional expectations
and martingales which lies at the heart of continuous-time models.

With this third motivation in mind, we develop notation for the binomial model which is
a bit different from that normally found in practice. Let us imagine that we are tossing a
coin, and when we get a “Head,” the stock price moves up, but when we get a “Tail,” the
price moves down. We denote the price at time one by S1 (H) = uS0 if the toss results in head
H, and by S1 (T ) = dS0 if it results in tail T. After the second toss, the price will be one of

S2 (HH) = uS1 (H) = u2 S0 ; S2 (HT ) = dS1 (H) = duS0

S2 (T H) = uS1 (T ) = udS0 ; S2 (T T ) = dS1 (T ) = d2 S0

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 After three tosses, there are eight possible coin sequences, although not all of them result
in different stock prices at time 3. For the moment, let us assume that the third toss is the
last one and denote by

= {HHH; HHT ; HT H; HT T ; T HH; T HT ; T T H; T T T }

The stock price Sk at time k depends on the coin tosses. To emphasize this, we often write
Sk (ω). Actually, this notation does not quite tell the whole story, for while S3 depends on
all of ω, S2 depends on only the first two components of ω, S1 depends on only the first
component of ω, and S0 does not depend on ω at all. Sometimes we will use notation such
S2 (ω1 ; ω2 ) just to record more explicitly how S2 depends on ω = (ω1 ; ω2 ; ω3 ).

9.2 General one-step APT

X0

∆0 S0 X0 − ∆0 S0

Suppose a derivative security pays off the amount V1 at time 1, where V1 is an F1 - measurable
random variable. (This measurability condition is important; this is why it does not make
sense to use some stock unrelated to the derivative security in valuing it, atleast in the
straightforward method described below).

• Sell the security for V0 at time 0. (V0 is to be determined later).

• Buy ∆0 shares of stock at time 0. ∆0 is also to be determined later

• Invest V0 − ∆0 S0 in the money market, at risk-free rate r. (V0 − ∆0 S0 might be negative)

• Then wealth at time 1 is

X1 (w) = ∆0 S1 (w) + (X0 − ∆0 So )(1 + r)

w = w1 = H(up) = ∆0 S1 (H) + (X0 − ∆0 S0 )(1 + r)

• we want to choose X0 and ∆0 so that

X1 = V1

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 regardless of whether the stock goes up or down

The last condition above can be expressed by two equations which is fortunate since there are
two unkowns:

S1 (H) V1 (H)
 
∆0 − S0 + X0 = (1)
1+r 1+r
S1 (T ) V1 (T )
 
∆0 − S0 + X0 = (2)
1+r 1+r
Since p̃ + q̃ = 1
p̃ and q̃ are like probabilities.
p̃(1) + q̃(2)

V1 (H)p̃ + V1 (T )q̃ S1 (H)p̃ + S1 (T )q̃

 
= ∆0 + X0
1+r 1+r
Find p̃ such that

S1 (H)p̃ + S1 (T )q̃
 
S0 = =0
1+r
p̃V1 (H) + q̃V1 (T )
Xo =
1+r
Where X0 is V0 ; law of one price
p̃uSo + q̃dS0
S0 =
1+r
(1+r) = p̃u+d-p̃d = p̃(u-d)+d

We have already assumed u > d > 0. Therefore,

1+r−d u−1−r
p̃ = u−d , q̃ = u−d .

Then p̃ > 0 and q̃ > 0. Since p̃ + q̃ = 1, we have 0 < p̃ < 1 and q̃ = 1 − p̃.
Thus, p̃, q̃ are like probabilities.
(1) − (2) =

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 S1 (H) − S1 (T ) V1 (H) − V1 (T )
 
∆0 =
1+r 1+r
V1 (H) − V1 (T )
∆0 =
S1 (H) − S1 (T )
X0 = p̌V1 (H) + q̌V1 (T )
Law of one price = V0

9.3 Risk-Neutral Probability Measure

p̃ is called the risk-neutral probability measure. We denote by Ẽ the expectation under p̃.
The above equation says

 
1 V1 (H)p̃+V1 (T )q̃ E(V1 )
V0 = Ẽ (1+r) V1 V0 = 1+r = 1+r
S1 (H)p̃+S1 (T )q̃
S0 = 1+r
= E(S
1+r
1)

Ẽ(V1 ) = V0 (1 + r)

Ẽ(S1 ) = S0 (1 + r)

The above two cases are under the risk neutral measure. Here the security Grows at risk free
rate. In general due to risk,

E(V1 ) > V 0 (1 + r)

E(S1 ) > S0 (1 + r)

The riskky assets behaves like a risk free assets.

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9.4 Example
Consider, u =2, d= .5, r = 25%, x= 5

1+r−d 3
p̃ = u−d = 6 = .5

therefore q = .5
E(V0 )
We know that, V0 = 1+r

1.5
= 1.2
1.25
V1 (H)−V1 (T )
Where, ∆0 = S1 (H)−S1 (T )

3−0
=
8−2
1
=
2

9. 5 Example
For the particular one-period model of, let S(O) = 4, u = 2, d = 12 . and r = l· Then S1 (H) = 8
and S1 (T ) = 2.
Suppose the strike price of the European call option is K = 5. Suppose further that we
begin with an initial wealth X0 = 1.20 and buy ∆0 = 12 shares of stock at time zero. Since
stock costs 4 per share at time zero, we must use our initial wealth X0 = 1.20 and borrow an
additional 0.80 to do this. This leaves us with a cash position X0 − ∆0 S0 = −0.80 (i.e., a debt
of 0.80 to the money market). At time one, our cash position will be (1 + r)(X0 − ∆0 S0 ) = −1
(i.e., we will have a debt of 1 to the money market). On the other hand, at time one we will
have stock valued at either 12 S1 (H) = 4 or 12 S1 (T ) = 1. In particular, if the coin toss results
in a head, the value of our portfolio of stock and money market account at time one will be
1
X( H) = s1 (H) + (1 + r)(X0 − ∆0 S0 ) = 3;
2
if the coin toss results in a tail, the value of our portfolio of stock and money market
account at time one will be
1
X1 (T ) = S1 (T ) + (1 + r)(X0 − ∆0 S0 ) = 0
2

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.
In either case. the value of the portfolio agrees with the value of the option at time one,
which is either (S1 (H) − 5) = 3 or (S1 (T ) − 5) = 0. We have replicated the option by trading
in the stock and money markets.

The initial wealth 1.2 needed to set up the replicating portfolio described above is the
no-arbitrage price of the option at time zero. If one could sell the option for more than this,
say, for 1.21, then the seller could invest the excess 0.01 in the money market and use the
remaining 1.20 to replicate the option. At time one, the seller would be able to pay off the
option, regardless of how the coin tossing turned out, and still have the 0.0125 resulting from
the money market investment of the excess 0.01. This is an arbitrage because the seller of the
option needs no money initially, and without risk of loss has 0.0125 at time one. On the other
hand, if one could buy the option above for less than 1.20, say, for 1.19, then one should buy the
option and set up the reverse of the replicating trading strategy described above. In particular,
sell short one-half share of stock, which generates income 2. Use 1.19 to buy the option, put
0.80 in the money market, and in a separate money market account put the remaining 0.01. At
time one, if there is a head, one needs 4 to replace the half-share of stock. The option bought
at time zero is worth 3, and the 0.80 invested in the money market at time zero has grown to 1.

At time one, if there is a tail, one needs 1 to replace the half-share of stock. The option is
worthless, but the 0.80 invested in the money market at time zero has grown to 1. In either
case, the buyer of the option has a net zero position at time one, plus the separate money
market account in which 0.01 was invested at time zero. Again, there is an arbitrage. We
have shown that in the market with the stock, the money market, and the option, there is an
arbitrage unless the time-zero price of the option is 1.20. If the time-zero price of the option
is 1.20, then there is no arbitrage.