Advanced Financial Mathematics

Chapter 10

Introduction to option pricing

binomial models
These notes are greatly inspired from the book Derivatives Markets

Chapter 10-Advanced Financial Mathematics-UEH-F2023 2

One-period binomial tree
• Consider a stock which does not pay dividends
• The stock price evoluates par période:
• increase up to a higher value « U=uS » ou
• Descrease down to a low value « D=dS », where 𝒅𝒅 < 𝟏𝟏 < 𝒖𝒖.

U=uS
S
D=dS

Chapter 10-Advanced Financial Mathematics-UEH-F2023 3

Risk-neutral Environment
• The goal is to establish what is called a "risk-neutral environment" in which
all investors are indifferent to risk.

• This implies that the asset S will, on average, evolve (in the risk-neutral
world) at a risk-free interest rate 𝑟𝑟𝑓𝑓 which means the expected return on
the asset is the risk-free rate:

𝑬𝑬∗ 𝑆𝑆𝑇𝑇 = 𝑆𝑆0 𝑒𝑒 𝑟𝑟𝑟𝑟 = S0 1 + rf T

• Risk-neutral valuation is a very important general result for pricing

derivative products.
Chapter 10-Advanced Financial Mathematics-UEH-F2023 4
Risk-neutral probabilities and risk neutral
measure
• If the probability that the asset S accumulates to reach uS is p*, then the probability
associated with the other potential value dS will be (1-p*).
• To be in a so-called "risk-neutral environment," it is necessary that (for a period of length
= 1):
𝑢𝑢𝑢𝑢 ∗ 𝑝𝑝∗ + 𝑑𝑑𝑑𝑑 ∗ 1 − 𝑝𝑝∗ = 𝑆𝑆(1 + 𝑟𝑟𝑓𝑓 )

1 + 𝑟𝑟 − 𝑑𝑑 𝑟𝑟 − 𝑑𝑑
𝑓𝑓 𝑒𝑒
𝑝𝑝∗ = =
𝑢𝑢 − 𝑑𝑑 𝑢𝑢 − 𝑑𝑑
• The probability p* is called « risk neutral probability», which can be used to define a new
probability measure Q.

• Q is called a risk –neutral measure.

Chapter 10-Advanced Financial Mathematics-UEH-F2023 5

First fundamental theorem of Mathematical
Finance

Theorem 1: The market is vital (i.e. there is no arbitrage opportunity) if

and only if there exists a risk neutral measure Q.

Chapter 10-Advanced Financial Mathematics-UEH-F2023 6

No arbitrage condition
• If the period length is equal to h, the risk neutral probability is given
by
𝑝𝑝∗ =

• For discret interest rate:

• For continuous interest rate:

Chapter 10-Advanced Financial Mathematics-UEH-F2023 7

Example
Assume the following binomial tree 60
50
40
If the force of interest rate is of 5% and the period lenght h = 1.
• Risk-neutral probability:
𝑝𝑝∗ =
Intepretation:

Chapter 10-Advanced Financial Mathematics-UEH-F2023 8

Risk neutral pricing formula
Theorem 2: In an 1-period binomial tree model with period length h=1, the call option price
is given by

𝑒𝑒 𝑟𝑟 − 𝑑𝑑 𝑢𝑢 − 𝑒𝑒 𝑟𝑟
𝐶𝐶 𝐾𝐾, 1 = 𝐶𝐶𝑢𝑢 ∗ 𝑝𝑝∗ + 𝐶𝐶𝑑𝑑 ∗ (1 − 𝑝𝑝∗ ) 𝑒𝑒 −𝑟𝑟 = 𝐶𝐶𝑢𝑢 ∗ + 𝐶𝐶𝑑𝑑 ∗ 𝑒𝑒 −𝑟𝑟
𝑢𝑢 − 𝑑𝑑 𝑢𝑢 − 𝑑𝑑
where 𝐶𝐶𝑢𝑢 (resp. 𝐶𝐶𝑑𝑑 ) represents the call payoff at the upper (resp. lower ) node de l’arbre
binomial.
• For a tree with period length h :
𝑟𝑟𝑟 − 𝑑𝑑 𝑟𝑟𝑟
𝑒𝑒 𝑢𝑢 − 𝑒𝑒
𝐶𝐶 𝐾𝐾, ℎ = 𝐶𝐶𝑢𝑢 ∗ 𝑝𝑝∗ + 𝐶𝐶𝑑𝑑 ∗ (1 − 𝑝𝑝∗ ) 𝑒𝑒 −𝑟𝑟𝑟 = 𝐶𝐶𝑢𝑢 ∗ + 𝐶𝐶𝑑𝑑 ∗ 𝑒𝑒 −𝑟𝑟𝑟
𝑢𝑢 − 𝑑𝑑 𝑢𝑢 − 𝑑𝑑
• The same formula is valid for put options.

Chapter 10-Advanced Financial Mathematics-UEH-F2023 9

Risk neutral pricing formula: General formula
Theorem 3: In a vital financial market, the call option price is given by
the following risk neutral pricing formula:

𝐶𝐶(𝐾𝐾, 𝑇𝑇) = 𝑬𝑬𝑸𝑸 [𝑒𝑒 −𝑟𝑟𝑟𝑟 𝑚𝑚𝑚𝑚𝑚𝑚 𝑆𝑆𝑇𝑇 − 𝐾𝐾, 0 ]

Chapter 10-Advanced Financial Mathematics-UEH-F2023 10

Example
Assume the following binomial tree model with h= 1 year,
uS = 60
Cu = (5)
S = 50
C = (2,9877)
dS = 40
Cd = (0)

Find the call option price with strike price K = 55$ which expires in one year.
Solution:

𝐶𝐶 55,1 =

Chapter 10-Advanced Financial Mathematics-UEH-F2023 11

Example (cont.)
• The put option price with the same characteristics is given by
𝑃𝑃 55,1 =

Chapter 10-Advanced Financial Mathematics-UEH-F2023 12

 Hedging strategy for a call option (without
dividends)
We consider the following stratgy:
• Buy ∆ shares of the underlying
• Borrow an amount of B ($)
• Goal: to replicate the call option at maturity in all market scenarios: VT = C
• Portfolio value at maturity:
• If ST equals 𝑈𝑈 = 𝑢𝑢𝑢𝑢, then VT = ∆𝑈𝑈 + 𝐵𝐵𝑒𝑒 𝑟𝑟𝑟
• If ST equals 𝐷𝐷 = 𝑑𝑑𝑑𝑑, then VT = ∆𝐷𝐷 + 𝐵𝐵𝑒𝑒 𝑟𝑟𝑟
• We have the following system with two variables (∆ and B):
∆𝑈𝑈 + 𝐵𝐵𝑒𝑒 𝑟𝑟𝑟 = 𝐶𝐶𝑢𝑢
�
∆𝐷𝐷 + 𝐵𝐵𝑒𝑒 𝑟𝑟𝑟 = 𝐶𝐶𝑑𝑑

Chapter 10-Advanced Financial Mathematics-UEH-F2023 13

Delta hedging strategy
• Solving the above system:
𝐶𝐶𝑢𝑢 − 𝐶𝐶𝑑𝑑 𝐶𝐶𝑢𝑢 − 𝐶𝐶𝑑𝑑
∆= =
𝑈𝑈 − 𝐷𝐷 𝑆𝑆(𝑢𝑢 − 𝑑𝑑)

𝑈𝑈 ∗ 𝐶𝐶𝑑𝑑 − 𝐷𝐷 ∗ 𝐶𝐶𝑢𝑢 𝑢𝑢 ∗ 𝐶𝐶𝑑𝑑 − 𝑑𝑑 ∗ 𝐶𝐶𝑢𝑢

𝐵𝐵 = 𝑒𝑒 −𝑟𝑟𝑟 = 𝑒𝑒 −𝑟𝑟𝑟
𝑈𝑈 − 𝐷𝐷 (𝑢𝑢 − 𝑑𝑑)

• No-arbitrage price:

ℎ𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 =

Chapter 10-Advanced Financial Mathematics-UEH-F2023 14

Interpretation

Chapter 10-Advanced Financial Mathematics-UEH-F2023 15

Remarks

Chapter 10-Advanced Financial Mathematics-UEH-F2023 16

Example
Consider the following binomial tree for h=1 year and the risk-free
interest rate (force) r = 8%.
Construct the hedging strategy for a call option with strike price K =
40$.
60
41
30
Chapter 10-Advanced Financial Mathematics-UEH-F2023 17
Solution
Tapez une équation ici.

Chapter 10-Advanced Financial Mathematics-UEH-F2023 18

 Binomial model with dividends
• Let 𝛿𝛿 be the dividend rate continuously paid.
• Risk neutral probability:
𝑝𝑝∗ =
• No-arbitrage condition:

Chapter 10-Advanced Financial Mathematics-UEH-F2023 19

 Delta hedging strategy with dividends
• To replicate the call option at maturity, we look at the following strategy:
• Buy ∆ shares
• Borrow an amount B
• Replicating: VT = C which leads to the system:

• Solving the system gives:

𝐶𝐶𝑢𝑢 − 𝐶𝐶𝑑𝑑 −𝛿𝛿𝛿 𝐶𝐶𝑢𝑢 − 𝐶𝐶𝑑𝑑
∆= 𝑒𝑒 = 𝑒𝑒 −𝛿𝛿𝛿
𝑈𝑈 − 𝐷𝐷 𝑆𝑆(𝑢𝑢 − 𝑑𝑑)
−𝑟𝑟𝑟
𝑈𝑈 ∗ 𝐶𝐶𝑑𝑑 − 𝐷𝐷 ∗ 𝐶𝐶𝑢𝑢 −𝑟𝑟𝑟
𝑢𝑢 ∗ 𝐶𝐶𝑑𝑑 − 𝑑𝑑 ∗ 𝐶𝐶𝑢𝑢
𝐵𝐵 = 𝑒𝑒 = 𝑒𝑒
𝑈𝑈 − 𝐷𝐷 𝑢𝑢 − 𝑑𝑑
• 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
Chapter 10-Advanced Financial Mathematics-UEH-F2023 20
 Binomial tree construction
• Define
𝑢𝑢 = 𝑒𝑒 𝑟𝑟−𝛿𝛿 ℎ+𝜎𝜎 ℎ 𝑑𝑑 = 𝑒𝑒 𝑟𝑟−𝛿𝛿 ℎ−𝜎𝜎 ℎ

where 𝜎𝜎 is the volatility parameter, h is the period length.

• Stock return in [t, t+h]:
𝑆𝑆𝑡𝑡+ℎ
𝑟𝑟𝑡𝑡,𝑡𝑡+ℎ = 𝑙𝑙𝑙𝑙 ↔ 𝑆𝑆𝑡𝑡+ℎ = 𝑆𝑆𝑡𝑡 𝑒𝑒 𝑟𝑟𝑡𝑡,𝑡𝑡+ℎ
𝑆𝑆𝑡𝑡
• Obverve that
𝑛𝑛−1
∑𝑛𝑛−1
𝑖𝑖=0 𝑟𝑟𝑡𝑡+𝑖𝑖𝑖,𝑡𝑡+(𝑖𝑖+1)ℎ
𝑟𝑟𝑡𝑡,𝑡𝑡+𝑛𝑛𝑛 = � 𝑟𝑟𝑡𝑡+𝑖𝑖𝑖,𝑡𝑡+(𝑖𝑖+1)ℎ ↔ 𝑆𝑆𝑡𝑡+ℎ = 𝑆𝑆𝑡𝑡 𝑒𝑒
𝑖𝑖=0

Chapter 10-Advanced Financial Mathematics-UEH-F2023 21

Example
• The daily stock price is given by the following table
Date 1 2 3 4
Prix 100$ 103$ 97$ 98$

The continuous stock return is given by

𝑆𝑆2 103
𝑟𝑟1,2 = 𝑙𝑙𝑙𝑙 = 𝑙𝑙𝑙𝑙 =0.02956;
𝑆𝑆1 100
97
𝑟𝑟2,3 = 𝑙𝑙𝑙𝑙 =0.02956
103
98
• 𝑟𝑟3,4 = 𝑙𝑙𝑙𝑙 =0.01026
97

Chapter 10-Advanced Financial Mathematics-UEH-F2023 22

 Volatility-Forward tree
• In the previous construction, σ represents the standard deviation of the
continuously composed stock return.
• Let σ be the annual, the variance of the return during one period with length
h is given by
𝜎𝜎ℎ2 = 𝜎𝜎 2 ℎ
Hence, 𝜎𝜎ℎ : = 𝜎𝜎 ℎ represents standardfor one period with length h.

• Recall that the forward price is given by: 𝐹𝐹𝑡𝑡,𝑡𝑡+ℎ = 𝑆𝑆𝑡𝑡 𝑒𝑒 𝑟𝑟−𝛿𝛿 ℎ , which means

𝑢𝑢𝑆𝑆𝑡𝑡 =

𝑑𝑑𝑆𝑆𝑡𝑡 =
Chapter 10-Advanced Financial Mathematics-UEH-F2023 23
Remarks
𝑢𝑢
=
𝑑𝑑

• Un biased-estimation of the historical volatility using the time series 𝑟𝑟𝑡𝑡,𝑡𝑡+ℎ

𝑆𝑆𝑡𝑡+ℎ
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑙𝑙𝑙𝑙
𝑆𝑆𝑡𝑡
= 𝜎𝜎�
ℎ

Chapter 10-Advanced Financial Mathematics-UEH-F2023 24

Estimation of the historical volatility

Chapter 10-Advanced Financial Mathematics-UEH-F2023 25

Multi-period binomial tree
• We define:
• 𝑛𝑛 = nomber of periods
• 𝑇𝑇 = Time to maturity (in years)
𝑇𝑇
• ℎ = = period length
𝑛𝑛
• For example, with S=1, n= 2, T = 2 and h = 1:

Chapter 10-Advanced Financial Mathematics-UEH-F2023 26

Remarks
To evaluate the value of an option, we will proceed as follows:
• Building the tree of stock prices from left to right.
• Building the tree with the option's value from right to left (in reverse), node by
node.
• The evaluation is always "risk-neutral" for the entire decision tree (each branch,
each node).
• For each node, the option's value can be reassessed. Thus, for each node, a new
replicating portfolio can be reassessed with a new Δ and a new B.
• The "risk-neutral" probabilities, as described earlier, do not change. However, the
replicating portfolio will evolve within the tree.

Chapter 10-Advanced Financial Mathematics-UEH-F2023 27

 Example
Find the call option with the following hypothesis:
T = 2 years, n = 2, h = 1 year, without dividend(𝛿𝛿 = 0), r = 8%, 𝜎𝜎 = 0% and S =
41,000$, K = 40,000$.

Chapter 10-Advanced Financial Mathematics-UEH-F2023 28

 Solution
• We deduce that
𝑢𝑢 =
𝑑𝑑 =

• Risk neutral probability:

𝑝𝑝∗ =

Chapter 10-Advanced Financial Mathematics-UEH-F2023 29

Solution

Chapter 10-Advanced Financial Mathematics-UEH-F2023 30

Solution (cont.)

Chapter 10-Advanced Financial Mathematics-UEH-F2023 31

 Solution(cont.): hedging strategy
• ∆=

• 𝐵𝐵 =

• ∆𝑢𝑢 =

• 𝐵𝐵𝑢𝑢 =

• ∆𝑑𝑑 =

• 𝐵𝐵𝑑𝑑 =
Chapter 10-Advanced Financial Mathematics-UEH-F2023 32
Pricing a put option

Chapter 10-Advanced Financial Mathematics-UEH-F2023 33

 Pricing an American option: main steps
With the binomial tree model, we can also assess whether it is advantageous to exercise
an option before its expiration. The process is as follows:

1. Build a tree for the evolution of the underlying asset (following the same structure as in
the previous section).

2. Determine the values at each time step at the option's expiration assuming that the
option is exercised at each node. This means calculating the payoff of the option at each
node if it were to be exercised immediately.

3. Compare the values at expiration obtained in step 2 with the European option price.

4. Continue this process from the final nodes back to the initial node to determine the
option's value at each step. Chapter 10-Advanced Financial Mathematics-UEH-F2023 34
Pricing an American option: Example
We'll revisit the example with the European call option, and now we assume
that the option is American. The parameters remain the same as before.

Chapter 10-Advanced Financial Mathematics-UEH-F2023 35

Observation: American call option

Chapter 10-Advanced Financial Mathematics-UEH-F2023 36

Pricing an American put option
The procedure is the same for a put option. The value of the option at each node is determined by:

1. Calculate the intrinsic value of the put option at each node, which is the difference between the strike
price (K) and the stock price (S) at that node.
2. Compare the intrinsic value to the calculated value at the next node based on the option pricing model.
Choose the higher value between the intrinsic value and the calculated value at the next node.
This procedure helps you assess whether it is advantageous to exercise an American put option early or
wait until expiration based on the intrinsic value and the option pricing model.

3. Continue this process from the final nodes back to the initial node to determine the option's value at
each step.

Chapter 10-Advanced Financial Mathematics-UEH-F2023 37

Pricing an American put option: example

Chapter 10-Advanced Financial Mathematics-UEH-F2023 38

Options on currency
• As was the case in the previous sections, you will express the option and its price in the
currency in which the option is denominated.
• Recall from chapter 9:
𝑇𝑇
1 + 𝑟𝑟𝐷𝐷
𝐹𝐹0,𝑇𝑇 = 𝑥𝑥0
1 + 𝑟𝑟𝐹𝐹
• The equivalent with continuous risk-free interest rate for a period of length "h" would be
as follows:
′
𝑟𝑟𝐷𝐷 −𝑟𝑟𝐹𝐹′ ℎ
𝐹𝐹0,ℎ = 𝑥𝑥0 𝑒𝑒
• Let x be the initial exchange rate. The binomial tree is constructed as follows:
′
𝑟𝑟𝐷𝐷 −𝑟𝑟𝐹𝐹′ ℎ+𝜎𝜎 ℎ
𝑈𝑈 = 𝑢𝑢𝑢𝑢 = 𝑥𝑥 𝑒𝑒
′
𝑢𝑢
𝑟𝑟𝐷𝐷 −𝑟𝑟𝐹𝐹′ ℎ−𝜎𝜎 ℎ
𝐷𝐷 = 𝑑𝑑𝑑𝑑 = 𝑥𝑥 𝑒𝑒
𝑑𝑑

Chapter 10-Advanced Financial Mathematics-UEH-F2023 39

Replicating portfolio for currency options

• For a stock option: The delta (Δ) represents the quantity of….

• For a currency option: The delta (Δ) involves….

Chapter 10-Advanced Financial Mathematics-UEH-F2023 40

Risk neutral probability for options on currency
• It is possible to consider the foreign risk-free interest rate as the dividend yield
component in the previous formulas, making the formulas almost identical.
• For options on stock:
𝑝𝑝∗ = ⏟
with dividends

• For option on currency:

𝑝𝑝∗ = ⏟
with foreign currency

Chapter 10-Advanced Financial Mathematics-UEH-F2023 41

Example

We'll revisit the example from illustration 10.9 in the reference book, with an
American put option on the euro, with the U.S. dollar as the local currency
(referred to simply as "dollar" for simplicity).
The initial exchange rate is 1,05 $/€, K = 1.10 $/€, σ = 0.10, 𝑟𝑟𝐷𝐷′ = 5.5%, 𝑟𝑟𝐹𝐹′ = 3.1%,
1 1
𝑇𝑇 = and 𝑛𝑛 = 3 (hence, ℎ = ).
2 6

Chapter 10-Advanced Financial Mathematics-UEH-F2023 42

Binomial tree

Chapter 10-Advanced Financial Mathematics-UEH-F2023 43

 Underlying dynamics and risk neutral
probability
1
• At t = =h:
6
𝑈𝑈 = 𝑥𝑥𝑥𝑥 =

𝐷𝐷 = 𝑥𝑥𝑥𝑥 =

𝑝𝑝∗ =

Chapter 10-Advanced Financial Mathematics-UEH-F2023 44

Calculation at each node of the binomial tree
• At node dd, we have:
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝑃𝑃𝑑𝑑𝑑𝑑 =

Chapter 10-Advanced Financial Mathematics-UEH-F2023 45

 Replicating portfolio
• To construct the replicating portfolio, the same logic applies with currency options as it did with
European options.
• It's important to note that for a node involving early exercise with an American option, the concept
of a "replicating portfolio" is somewhat abstract since the option ends at the time of exercise.
• For nodes involving early exercise, the choice is to sell the underlying asset without a doubt. The
foreign risk-free interest rate being treated as a dividend yield in the formulas, we revisit the
hedging formula and adjust it for an American put option:

𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃𝑑𝑑𝑑𝑑𝑑𝑑 − 𝑃𝑃𝑑𝑑𝑑𝑑𝑑𝑑 −𝑟𝑟 ′ ℎ 0.08 − 0.16 −0.031

∆𝑑𝑑𝑑𝑑 = 𝑒𝑒 𝐹𝐹 ↔ 𝑒𝑒 6 = −0.995
𝐷𝐷𝐷𝐷𝐷𝐷 − 𝐷𝐷𝐷𝐷𝐷𝐷 1.02 − 0.94
=−1

𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 ′
−𝑟𝑟𝐷𝐷 ℎ
𝐷𝐷𝐷𝐷𝐷𝐷 ∗ 𝑃𝑃𝑑𝑑𝑑𝑑𝑑𝑑 − 𝐷𝐷𝐷𝐷𝐷𝐷 ∗ 𝑃𝑃𝑑𝑑𝑑𝑑𝑑𝑑 −
0.055 1.02 ∗ 0.16 − 0.94 ∗ 0.08
𝐵𝐵𝑑𝑑𝑑𝑑 = 𝑒𝑒 = 𝑒𝑒 6 = 1.09
𝐷𝐷𝐷𝐷𝐷𝐷 − 𝐷𝐷𝐷𝐷𝐷𝐷 1.02 − 0.94
All the calculations shown earlier apply in the same way for all nodes of the tree. The remaining nodes
are left to be addressed through exercises.

Chapter 10-Advanced Financial Mathematics-UEH-F2023 46

Option on futures
• The concept of issuing a derivative on another derivative may seem abstract.
• In this context, an option on a futures contract implies the right to buy or sell a
futures contract before its expiration.
• This results in having both the option's expiration and the futures contract's
expiration.
• The option's expiration date must be earlier than that of the futures contract.

Chapter 10-Advanced Financial Mathematics-UEH-F2023 47

Calculation of the underlying asset 𝑭𝑭𝒕𝒕,𝑻𝑻
• We define the futures price as the forward price and replace the
underlying St with 𝐹𝐹𝑡𝑡,𝑇𝑇 .
• If we revisit the model with the underlying asset price as the basis of
the binomial tree, we have:

Chapter 10-Advanced Financial Mathematics-UEH-F2023 48

Binomial tree for the underlying asset 𝑭𝑭𝒕𝒕,𝑻𝑻
• Since the futures price already includes the accumulation of the
current underlying asset price at the risk-free interest rate, we have
𝑢𝑢𝐹𝐹 = 𝑒𝑒 𝜎𝜎 ℎ et 𝑑𝑑𝐹𝐹 = 𝑒𝑒 −𝜎𝜎 ℎ

Chapter 10-Advanced Financial Mathematics-UEH-F2023 49

Risk neutral probability
• Risk neutral probability:
∗ 𝐹𝐹𝐹𝐹𝐹𝐹 1 − 𝑑𝑑𝐹𝐹
𝑝𝑝 =
𝑢𝑢𝐹𝐹 − 𝑑𝑑𝐹𝐹
Note:

Chapter 10-Advanced Financial Mathematics-UEH-F2023 50

Remarks

Chapter 10-Advanced Financial Mathematics-UEH-F2023 51

Replicating portfolio
∆ ∗ 𝐹𝐹𝑑𝑑𝐹𝐹 − 𝐹𝐹 + 𝑒𝑒 𝑟𝑟𝑟 ∗ 𝐵𝐵 = 𝐶𝐶𝑑𝑑𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹

∆ ∗ 𝐹𝐹𝑢𝑢𝐹𝐹 − 𝐹𝐹 + 𝑒𝑒 𝑟𝑟𝑟 ∗ 𝐵𝐵 = 𝐶𝐶𝑢𝑢𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹

• Note:
• Therefore:
∆=

𝐵𝐵 =

where ∆ represents the number of futures to buy/sell in order to replicate the

option.

Chapter 10-Advanced Financial Mathematics-UEH-F2023 52

Example

We will now revisit illustration 10.10 (DM) with an American call

option, with T = 1, n = 3, K= 300 000, 𝑟𝑟 = 𝛿𝛿 = 5% , 𝐹𝐹0,𝑇𝑇 = 300 000,
𝜎𝜎 = 10%.

Chapter 10-Advanced Financial Mathematics-UEH-F2023 53

Solution

Chapter 10-Advanced Financial Mathematics-UEH-F2023 54

Solution(cont.)

Chapter 10-Advanced Financial Mathematics-UEH-F2023 55

Remarks

Chapter 10-Advanced Financial Mathematics-UEH-F2023 56