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1
A Simple Binomial Model
2
A Call Option
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Setting Up a Riskless Portfolio
For a portfolio that is long D shares, and a
short 1 call option values are
22D – 1
18D
5
Valuing the Option
The portfolio that is
long 0.25 shares
short 1 option
is worth 4.455
The value of the shares is
5.00 (= 0.25 × 20 )
The value of the option is therefore
5.00 – 4.455 = 0.545
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Generalization
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Generalization
Value of a portfolio that is long D shares and short
1 derivative:
S0uD – ƒu
S0dD – ƒd
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Generalization
Value of the portfolio at time T is S0uD
– ƒu
Value of the portfolio today is (S0uD –
ƒu)e–rT
Another expression for the portfolio
value today is S0D – f
Hence
ƒ = S0D – (S0uD – ƒu )e–rT
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Generalization
(continued)
where
e rT − d
p=
u−d
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p as a Probability
It is natural to interpret p and 1-p as probabilities of up
and down movements
The value of a derivative is then its expected payoff in
a risk-neutral world discounted at the risk-free rate
S0u
ƒu
S0
ƒ
S0d
ƒd
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Risk-Neutral Valuation
When the probability of an up and down
movements are p and 1-p the expected stock price
at time T is S0erT
This shows that the stock price earns the risk-free
rate
Binomial trees illustrate the general result that to
value a derivative we can assume that the
expected return on the underlying asset is the risk-
free rate and discount at the risk-free rate
This is known as using risk-neutral valuation
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Original Example Revisited
S0u = 22
ƒu = 1
S0=20
ƒ
S0d = 18
ƒd = 0
13
Valuing the Option Using Risk-Neutral
Valuation
S0u = 22
ƒu = 1
S0=20
ƒ
S0d = 18
ƒd = 0
14
A Two-Step Example
24.2
22
20 19.8
18
16.2
K=21, r = 4%
Each time step is 3 months
15
Valuing a Call Option
24.2
3.2
22
B
20 1.7433 19.8
0.9497 A 0.0
18
0.0 16.2
0.0
Value at node B
= e–0.04×0.25(0.5503×3.2 + 0.4497×0) = 1.7433
Value at node A
= e–0.04×0.25(0.5503×1.7433 + 0.4497×0) = 0.9497
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Example: Put Option
Consider a 2-year put option with strike
price of Rs.52 on a stock whose current
price is Rs.50. Suppose that there are two
times of 1 year, and each time step the
stock price either moves up by 20% or
moves down by 20%. The risk-free rate is
5%.
19
A Put Option Example
72
0
60
50 1.4147 48
4.1923 4
40
9.4636 32
20
20
What Happens When the Put Option
is American
72
0
60
50 1.4147 48
5.0894 4
40
The American feature C
increases the value at node 12.0 32
C from 9.4636 to 12.0000. 20
21
Delta
22
Choosing u and d
One way of matching the volatility is to
set
u = es Dt
d = 1 u = e −s Dt
24
The Probability of an Up Move
a−d
p=
u−d
( r − r ) Dt
a=e f for a currency where r f is the foreign
risk - free rate
25
Example
Consider an American put option where
the stock price is Rs.50, the strike price is
Rs.52, the risk-free rate is 5%, the life of
the option is 2 years, and there are two-
time steps. The volatility is 30%.
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Example
A stock index is currently 810 and has a
volatility of 20% and dividend yield of 2%.
The risk-free rate of interest is 5%.
Determine the value of the European call
option with a strike price 800 using two
step binomial tree.
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