Lecture 5 1st and 2 st Binomial Model algorithms - (L5)

(i) A brief version of the general terminology is stated.

(ii) One step binomial model is introduced as a computer algorithm.
(iii) Then also two-step binomial model is introduced as a computer algorithm.

General terminology. n, k, t=0,1,. . . = discrete time;

0=origin;
T =expiry time;
Sk =share price at time k;
Y =risky return with two values, P (Y = u) + P (Y = d) = 1, 0 < P (Y = u) < 1;
u=move up of the share price;
d=move down of the share price;

Sk+1 = Sk u
%
dynamics of share prices: Sk
&
Sk+1 = Sk d
r=fixed interest rate;
1 → 1 + r → (1 + r)2 → ... = dynamics of bond prices;
risky asset=share;
non-risky/riskless asset=bond;
C = f (ST )=claim option/payoff (how much we want to get);
OP=OP(C) =option price;
(x0 , x1 )=portfolio invested at time 0 with
x0 =invested in bonds/number of bonds and x1 =invested in shares/number of shares;
Wk =capital at time k, in particular W0 = x0 + x1 S0 since the price of one bond is 1;
(x0 , x1 ) is called hedging portfolio if WT = C; then W0 = x0 + x1 S0 =OP.

1 step Binomial Model algorithm.

St 1 Identify the q-probabilities defined by
1+ρ−d
qu = , q d = 1 − qu
u−d
St 2 Write down the one-step binomial tree defined by
S1 = S0 u ; Cu with qu
%qu
S0
&qd
S1 = S0 d ; Cd , with qd
St 3 Compute the OP (option price) from the diagram and using the general one-step OP-formula
1
OP = OP(C) = [Cu qu + Cd qd ]
1+ρ

1
St 4 Find the hedging portfolio (x0 , x1 ), defined by

Cu − Cd uCd − dCu
x1 = x0 =
S0 (u − d) (1 + ρ)(u − d)

and use the right financial interpretation:

x0 > 0=buy bonds , x0 < 0=borrow bonds,
x1 > 0=buy shares , x1 < 0=borrow/short sell shares.
St 5 Check yours answers via

W0 = x0 + x1 S0 = OP(C)

2
2 step Binomial Model algorithm.
St 1 As before Identify the q-probabilities defined by
1+ρ−d
qu = , q d = 1 − qu
u−d
St 2 Write down the two-step binomial tree defined by

S2 = S0 u2 , Cuu = f (S0 uu)

qu
% with qu2
S1 = S0 u
%qu &qd
S0 S2 = S0 ud , Cud = f (S0 ud)
&qd %qu with 2qu qd
S1 = S0 d
&qd
S2 = S0 d2 , Cdd = f (S0 dd)
with qd2

St 3 Compute the OP (option price) from the diagram and using the two-step general OP -
formula

OP = OP(C) = (1 + ρ)−2 [Cuu qu2 + Cud 2qu qd + Cdd qd2 ]

St 4 To compute the OP(C 0 ) = v(u) for the u-block when S1 = uS0 = S00 , apply the diagram

S10 = S00 u = S0 u2 ; Cu0 = Cuu , with qu

qu
%
S00 = S1 = S0 u

&qd
S10 = S00 d = S0 ud ; Cd0 = Cud = 0, with qd

and the u-block option price is

1
OP(C 0 ) = v(u) = (C 0 qu + Cd0 qd )
1+ρ u
1
= (Cuu qu + Cud qd )
1+ρ

St 5 Similarly, the OP(C 00 ) = v(d) for the d-block when S1 = dS0 = S000 , is defined by the diagram

S100 = S000 u = S0 ud ; Cu00 = Cud , with qu

qu
%
S000 = S1 = S0 d

&qd
S100 = S000 d = S0 d2 ; Cd00 = Cdd = 0, with qd

3
and the d-block option price is
1
OP(C 00 ) = v(d) = (Cu00 qu + Cd00 qd )
1+ρ
1
= (Cud qu + Cdd qd )
1+ρ
St 6 The initial hedging portfolio is

v(u) − v(d) uv(d) − dv(u)

x1 = , x0 =
S0 (u − d) (1 + ρ)(u − d)

with he interpretation as for the 1 step:

x0 > 0=buy bonds , x0 < 0=borrow bonds,
x1 > 0=buy shares , x1 < 0=borrow/short sell shares.
St 7 And again, check yours answers via

W0 = x0 + x1 S0 = OP(C)