Lecture 14

Multiple-Step Binomial Tree Models

Yicheng Zhu

1 Apr 2022

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Outline

1. Two-Step Binomial Trees and Dynamic Trading

2. Multi-Step Binomial Trees

3. Pricing on Multiple-Step Binomial Trees

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Extending the One-step Binomial Tree Model

So far we have covered one-step binomial tree for option pricing.

I The model allows us to again facilitate the replication argument and price assets,
although the payoff function of the derivatives might no longer be liner (a straight
line).

I However, this model is very unappealing as the assumption (two states) is very strong
and far away from reality.

I One way to resolve the issue is by thinking about multiple steps for a binomial tree.

I The following example will illustrate the idea.

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Two-step Binomial Tree Model: an Example

Suppose today at time t, stock ABC is traded at St $100 per share. 6 months later, it has
a p = 60% probability of going up by 2%, and a probability of 1 − p = 40% going down
by 1.96%. The stock price can further move with the same change in percentage and
probability 1 year later. The risk-free interest rate is 0%, constant.

St+1 = 104.04
p = 60%

St+0.5 = 102
p = 60%

1 − p = 40%
St = 100 St+1 = 100
p = 60%

1 − p = 40%
St+0.5 = 98.04

1 − p = 40%
St+1 = 96.12

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Two-step Binomial Tree Model: an Example

St+1 = 104.04
p = 60%

St+0.5 = 102
p = 60%

1 − p = 40%
St = 100 St+1 = 100
p = 60%

1 − p = 40%
St+0.5 = 98.04

1 − p = 40%
St+1 = 96.12

Suppose at time t the investor wants to purchase a call option with strike price 98 and
maturity 1 year. What is the fair price for the option?

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Recursive Pricing

One way of solving the problem is to solve the price of the call option recursively.

I You start with the terminal payoffs, and then can solve the prices of the call option
one period ahead.

I After solving the prices of the call option one period ahead of the maturity in all
states, move one step ahead.

I Each step requires fewer states to solve, and eventually we end up with the initial
point.

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Two-step Binomial Tree Model: an Example (Cont’d)

We first consider ‘conventional’ method of replication. Consider the ‘upper’ sub-tree, a

St+1 = 104.04
p = 60%

St+0.5 = 102

1 − p = 40%
St+1 = 100

The payoff of the call option is given by $6.04 and $2, respectively, or

St+1 = 104.04
p = 60% Ct+1 = 6.04
St+0.5 = 102
Ct+0.5
1 − p = 40%
St+1 = 100
Ct+1 = 2

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Two-step Binomial Tree Model: an Example (Cont’d)

St+1 = 104.04
p = 60% Ct+1 = 6.04
St+0.5 = 102
Ct+0.5 = 4
1 − p = 40%
St+1 = 100
Ct+1 = 2

We want to solve for the fair price of the option at t + 0.5, if the stock price goes up.
I The ∆ now is
6.04 − 2
∆= = 1.
104.04 − 100
I In addition, we need to carry 2 − 100 × 1 = −98 in zero-coupon bonds.

I That means that, at time t + 0.5, we need to pay 102 × 1 − 98 = 4 to replicate the
payoff of the option, if the stock price goes up.

I This must also be the price (value) of the call option.

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Two-step Binomial Tree Model: an Example (Cont’d)

Now let’s consider the ‘lower’ half of the tree:

St+1 = 100
p = 60% Ct+1 = 2
St+0.5 = 98.04
Ct+0.5
1 − p = 40%
St+1 = 96.12
Ct+1 = 0

I The ∆ now is
2−0
∆= = 0.515.
100 − 96.12
I In addition, we need to carry 0 − 96.12 × 0.515 = −49.50 in zero-coupon bonds.

I That means that, at time t + 0.5, we need to pay 98.04 × 0.515 − 49.50 = 0.99 to
replicate the payoff of the option, if the stock price goes down.

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Two-step Binomial Tree Model: an Example (Cont’d)

Now we know perfectly how much the option should cost at time t + 0.5.

St+0.5 = 102
p = 60% Ct+0.5 = 4
St = 100
Ct
1 − p = 40%
St+0.5 = 98.04
Ct+0.5 = 0.99

I The ∆ now is
4 − 0.99
∆= = 0.76.
102 − 98.04
I In addition, we need to carry 4 − 102 × 0.76 = −73.52 in zero-coupon bonds.

I That means that, at time t, we need to pay 100 × 0.76 − 73.52 = 2.48 to replicate
the payoff of the option.

I The call option should then cost $2.48.

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Dynamic Trading

All the calculation before implies a trading strategy that can replicate the payoff of the call
option:

I Start with ∆ = 0.76, and the corresponding zero coupon bonds.

I After 1 period, at t + 0.5, adjust the stock holding to the corresponding ∆ of the
nodes.

I The trading strategy here contains adjustment of the portfolio, while in previous
models the portfolio composition is fixed.

I The strategy here is called dynamic replicating trading strategies, while holding a
fixed portfolio is called static replicating trading strategies.

I Unsurprisingly, dynamic replicating trading strategies are useful only if we work with
binomial trees with more than one step.

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Dynamic replication

I The portfolio also contains no external cash flow after initialization.

I If you adjust your portfolio, you fund the adjustment using bonds and then put the
bonds in your portfolio, and as a result the value of your portfolio does not change.

I The fact that the strategy does not need further external cash flows suggests that
this strategy is a self-financing dynamic trading strategy.

I Definition: A self-financing dynamic trading strategy is a strategy that does not have
any infusion or withdrawal of money after the initial purchase/sale of assets at time 0.

I The present value of the payoff at time T from such a strategy is the time 0 cost of
setting up the strategy (otherwise arbitrage: buy low, sell high)

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Risk Neutral Pricing

I The risk-neutral probability q of going up at each node must suffice

1 = q + (1 − q)
1
S = qS × 1.02 + (1 − q)S × .
1.02
I As a result, q is given by
1
1 − 1.02
q= 1
= 49.5%.
1.02 − 1.02

I Question: Why q are the same for all nodes?

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Risk Neutral Pricing

I The call option price if the stock price goes up in the first period then must be

6.04 × q + 2 × (1 − q) = 4.
I The call option price if the stock price goes down in the first period then must be

2 × q + 0 × (1 − q) = 0.99.
I The call option price at initiation then must be

4 × q + 0.99 × (1 − q) = 2.48.

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Risk Neutral Pricing (cont’d)

I Again the result must be the same for the two approaches as risk neutral pricing is
equivalent to absence of arbitrage.

I However, the calculation with risk-neutral pricing is must easier.

I Absence of arbitrage argument, however, tells what actual trading strategies are
needed to replicate the payoff of the derivative.

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Outline

1. Two-Step Binomial Trees and Dynamic Trading

2. Multi-Step Binomial Trees

3. Pricing on Multiple-Step Binomial Trees

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Multiple-step Trees

I The most important advantage of two-step binomial tree over one-step binomial tree
is that the former allow a much richer characterization of the terminal payoff.

I However, for each step, there could be only two outcomes, and this allows to replicate
the dynamics of the derivative price movement using the underlying and bond only.

I A natural extension is to cut the price movement into even finer steps, but keep the
binomial tree structure. This allows us to get a much accurate approximation of the
reality.

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Setting Up Multiple-step Trees

I We want to use a n-step tree to approximate the return of an asset from time t to
t + T.

I Question: How to set up the tree?

I A standard algorithm goes like this:

I We chop off the time interval [t, t + T ] evenly into n small intervals

I Each interval is of size h = T /n. We denote the steps i = 0, 1, ..., n

=⇒ i × h = calendar time on the tree

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Calibrate Multiple-step Tree Parameters

I Assume the asset has log expected constant return µ and constant volatility σ

I Then, over a small interval of time h:

I Expected return is  
St+h
Et = e µ×h
St
I Conditional variance is
" 2 #
St+h
Et − e µ×h = σ2 × h
St

I We want our tree match these moments for each step.

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Calibrate Multiple-step Tree Parameters (Cont’d)

I Assume that the stock prices evolves according to:


Si × (1 + u) with probability p
Si+h =
Si × (1 + d) with probability 1−p

I We now choose u, d and p to approximate the expected return µ and variance σ 2 on

the tree

I The following conditions must be satisfied:

 
Si+1
1. Expected Return: Et Si
= e µ×h =⇒

p × (1 + u) + (1 − p) × (1 + d) = e µ×h

 2 
Si+1
2. Variance: Et Si
− e µ×h
= σ 2 × h =⇒
 2  2
p 1 + u − e µ×h + (1 − p) 1 + d − e µ×h = σ 2 × h

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Calibrate Multiple-step Tree Parameters (Cont’d)

I We have two equations, but three parameters, and can not uniquely solve for the
parameters.

I One easy way to fix this is to assume

(1 + u)(1 + d) = 1,

and this implies that the price remains the same after one ‘up’ and one ’down’.

I The solution is then

√ √
e µ×h − (1 + d)
1 + u = e σ× h
; 1 + d = e −σ×h
; and p = .
u−d
I Next figure shows an example from BinomialTree.xls

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Multiple-step trees: a pricing tool

I Time index: i = 0, 1, ..., n. Node index: j = 0, 1, ...., n

I Because we start from up-left corner
I an up movement in S between i and i + 1 correspond to same index j;
I a down movement in S between i and i + 1 corresponds to an increase in the index j.

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Outline

1. Two-Step Binomial Trees and Dynamic Trading

2. Multi-Step Binomial Trees

3. Pricing on Multiple-Step Binomial Trees

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Multiple-step Trees: Derivative Pricing

I The simplest way of pricing derivatives using multi-step binomial tree is to use
risk-neutral pricing.

I The risk neutral probability of going up is given by

e r ×h − (1 + d)
q=
u−d
Since u, d, h are the same for each step, q remains constant. r is the risk-free rate.

I Move backward on the tree one step at a time:

Vi,j = e −r ×h × Eq [Vi+1 |(i, j)]
where i, j is the (time, node) state on the tree.

I For instance, for call options, start from the end of the tree with the final condition

Cn,j = max(Sn,j − K , 0) for j = 0, 1, ..., n

I Then move backward applying

Ci,j = e −r ×h × (qCi+1,j + (1 − q)Ci+1,j+1 )

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Multiple-step trees: example

Option Price

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Multiple-step trees: example with 250 steps

time ==> 0.000 0.000 0.001 0.001 0.002 0.002 0.002 0.003 0.003 0.004 0.004
i==> 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0
0 3.876 4.193 4.527 4.879 5.247 5.633 6.036 6.457 6.894 7.348 7.818
1 3.561 3.861 4.177 4.511 4.863 5.231 5.618 6.021 6.442 6.879
2 3.262 3.545 3.845 4.161 4.495 4.847 5.216 5.602 6.005
3 2.980 3.246 3.529 3.828 4.145 4.479 4.831 5.200
4 2.715 2.964 3.230 3.513 3.812 4.129 4.463
5 2.466 2.699 2.949 3.214 3.497 3.796
6 2.233 2.451 2.684 2.933 3.198
7 2.016 2.218 2.436 2.668
8 1.814 2.002 2.204
9 1.628 1.801
10 1.455

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Multiple-step Trees: Probability Distribution of ST

I What is the probability distribution of the stock price at maturity ST ?

I Consider an n-step tree

I There are n + 1 nodes at maturity, j = 0, 1, ..., n

I The top node j = 0 can only be reached with n ups u and 0 downs d
I Node j = 1 can only be reached with n − 1 ups u and 1 down d
.. ..
. .
I Node j = n can only be reached with 0 ups u and n downs d

I If each up u has risk-neutral probability q, what is the probability of reaching

exactly node j?
 
n!
P (node = j at T = n × h) = × (q)n−j × (1 − q)j
j!(n − j)!
where n! = 1 × 2 × 3 × ... × n (note: 0!=1)

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Multiple-step trees: probability distribution of ST

As n increases to infinity, the distribution at T = n × h of the stock price ST converges to

a log-normal distribution.

Probabilities of ST for n = 250 and T = 1

0 06
0.06

0.05

0.04

0.03

0.02

0.01

0
0 100 200 300 400 500
Ͳ0.01
STOCK PRICE

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Multiple-step trees: probability distribution of ST
Or, plotting the probability density with respect to log(ST ), we obtain

0.06

0.05

0.04

0.03 BinomialTree
NormalDist

0.02

0.01

0
3.5 4 4.5 5 5.5 6

Log Stock Price

This will be used as an assumption directly for a model later in the course.
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Conclusion

I Binomial trees are very useful tools for derivative pricing

I They can be easily programmed on computers to price derivative security recursively
(sometimes called backward induction..)
I We can use them to compute the positions in the dynamic replication portfolio.
I As we will see, we can also use binomial trees to compute the value of American options
(much harder than Europeans), and price more complicated exotic. securities

I Risk neutral pricing is another useful tool for pricing securities.

I It is just a tool, and it does not require the assumption that agents are risk neutral!
I The risk neutral methodology stems from the fact that we can use a replicating
portfolio to hedge the exposure from a derivative security.

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