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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 who’s utility function?
– in fact we’ll see there’s 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
1−p
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
1−p
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 buyer’s (or seller’s) utility
function.
4
Derivative Security Pricing
C1 (S1 )
a
p
uS0 Cu
ah
S0 hhh hhh
1−p
hhha
dS0 Cd
t=0 t=1
uS0 x + Ry = Cu
dS0 x + Ry = Cd
5
Derivative Security Pricing
Obtain
1 R−d u−R
C0 = Cu + Cd
R u−d u−d
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
What’s 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