Multi-Period Binomial Models 1

Multi-Period Binomial Basics

Replicating Multi-Period Binomial Options
Risk-Neutral Approach
Exercises

Multi-Period Binomials 2

Binomial models can cover multiple time periods. Want to price a European call with
S0 = 100, T = 2 and K = 95, assuming binomial model with u = 1.1, d = 0.9, a step
every 1 time unit, and a risk free rate of 4%.

u 2 S0 = 121

uS0 = 110

S0 = 100 udS0 = 99

dS0 = 90

d 2 S0 = 81

Here u and d are constant, so the tree recombines (i.e., udS = duS). Text exercises
and examples assume that, but it is neither necessary nor stated as requirement in text.
Solving Multi-Period Binomials 3

European call option, strike price at T = 2 is K = 95.

u 2 S0 = 121
Cuu = 26
uS0 = 110
Cu
S0 = 100 udS0 = 99
C0 Cud = Cdu = 4
dS0 = 90
Cd
d 2 S0 = 81
Cdd = 0

Approach :
1. Start by computing the option payoffs at expiration at the far right of the tree
2. Work backwards through the tree (i.e., right to left) solving each individual
binomial step in the tree for the binomial option price

Finding Cu 4

Cu is the option value if stock went up to 110 in step 1.

2 cases: Go up again to 121, payoff is 26
Go down to 99, payoff is 4
r = 0.04
At time 1, want au in risk free asset, bu shares of stock

au e 0.04 + 121bu = 26
au e 0.04 + 99bu = 4
22bu = 22 ⇒ bu = 1
au = −91.275
Cu = au + 110 · bu
= 18.725
Finding Cd 5

Cd is the option value if stock went down to 90 in step 1.

Same logic as with Cu , just different payoffs.

Again 2 cases: Go back up to 99, payoff is 4

Go down again to 81, payoff is 0
r = 0.04
At time 1, want ad in risk free asset, bd shares of stock
(Subscripts denote what previously happened)
ad e 0.04 + 99bd = 4
ad e 0.04 + 81bd = 0
18bd = 4 ⇒ bd = 4/18
ad = −17.294
Cd = ad + 90 · bd
= 2.706

Finding C0 6

C0 is the option value at time 0.

Our time 0 replicating portfolio needs to yield: Cu or Cd at time 1.
Have a0 in risk free asset, b0 shares of stock:

a0 e 0.04 + 110b0 = Cu = 18.725

a0 e 0.04 + 90b0 = Cd = 2.706
20b0 = 16.02 ⇒ b0 = 0.801
a0 = −66.663
C0 = a0 + 100 · b0
= 13.436
Replication Remarks 7

Our portfolio was ‘self-financing’:

• Start with b0 = 0.801 shares, borrow 66.663
• If stock goes up to 110, want bu = 1 share, borrow 91.275
• Need 0.199 more shares
• That will cost 0.199 · 110 = 21.89 more
• Borrow 91.275 − 66.663 · e 0.04 = 21.89 more
• If stock goes down, want 2/9 of a share, borrow 17.294
• Sell 0.801 − 2/9 = 0.579 shares
• Get 0.579 · 90 = 52.09
• Owe 66.663 · e 0.04 − 52.09 = 17.294
• In both cases, get the portfolio we want at time 1
• Don’t need to add / remove more money at time 1

Risk-Neutral Approach 8

u − er
Or, if q = is chance of going down at each individual step, and 1 − q is chance
u−d
of going up, and h(ST ) = payoff at time T ,
 −2r
C0 = EQ

0 e h(ST )
h
= e −2·0.04 (1 − q)2 · 26 + 2q(1 − q) · 4 + q 2 · 0


110
u= = 1.1
100
90
d= = 0.9
100
1.1 − e 0.04
q= = 0.296
1.1 − 0.9
C0 = e −.08 (1 − 0.296)2 · 26 + 2(0.296)(1 − 0.296) · 4 + 0
 

= 13.436

Which is way faster than what we did before.

Exercise 1 9

For an at the money put with S0 = 50, T = 2, u = 1.06, d = 0.96 and a step every 1
time unit, assuming a risk free rate of 3%, use a binomial tree to find the initial put
price p0 , as well as the possible put prices pd and pu at time 1.

Exercise 1 9

For an at the money put with S0 = 50, T = 2, u = 1.06, d = 0.96 and a step every 1
time unit, assuming a risk free rate of 3%, use a binomial tree to find the initial put
price p0 , as well as the possible put prices pd and pu at time 1.

u 2 S0 = 56.18
Puu = 0
uS0 = 53
Pu = 0
S0 = 50 udS0 = 50.88
P0 Pud = 0
dS0 = 48
Pd
d 2 S0 = 46.08
Pdd = 3.92
Exercise 1 (Cont) 10

au · e r ·1 + bu (uS0 ) · u = 0
au · e r ·1 + bu (uS0 ) · d = 0
au = bu = 0
pu = 0
ad · e r ·1 + bd (dS0 ) · u = 0
ad · e r ·1 + bd (dS0 ) · d = 3.92
0 − 3.92
bd = = −0.8167
50.88 − 46.08
ad = 0 − 50.88 · (−0.8167) e −0.03 = 40.324

pd = 40.324 − 0.8167 · 48 = 1.124

Exercise 1 (last part) 11

a0 · e 0.03 + b0 S0 · u = pu = 0
a0 · e 0.03 + b0 S0 · d = pd = 1.124
b0 (53 − 48) = 0 − 1.124
−1.124
b0 =
5
= −0.2248
a0 = 0 − 53(−0.2248) e −0.03
 

= 11.56
p0 = 11.56 + 50(−0.2248)
= 0.32
Exercise 2 12

For an at the money put with S0 = 50, T = 2, u = 1.06, d = 0.96 and a step every 1
time unit, assuming a risk free rate of 3%, use the risk neutral measure to find the
initial put price p0 , as well as the possible put prices pd and pu at time 1.

Exercise 2 12

For an at the money put with S0 = 50, T = 2, u = 1.06, d = 0.96 and a step every 1
time unit, assuming a risk free rate of 3%, use the risk neutral measure to find the
initial put price p0 , as well as the possible put prices pd and pu at time 1.

u − er 1.06 − e 0.03
q= = = 0.2955
u−d 1.06 − 0.96
−r
pu = EQu [e h(S2 )]
= e −r (1 − q) · 0 + q · 0 = 0
 

pd = e −r (1 − q) · 0 + q · 3.9) = 1.124
 

−2r
p0 = EQ0 [e h(ST )]
= e −2r (1 − q)2 · 0 + 2q(1 − q) · 0 + q 2 · 3.92
 

= e −0.06 (0.2955)2 (3.92)

= 0.322