Binomial Tree - Summary

erδt snow − sdown

q = fup − fdown
sup − sdown φ =
−rδt
sup − sdown
fnow = e (qfup + (1 − q)fdown ) −1
ψ = Bnow (fnow − φsnow )
= f (1) = EQ BT−1 X


V

where

q: arbitrage probability of up-jump r: interest rate in force over period

f : claim value time-process
φ: stock holding strategy
ψ: bond holding strategy
V : claim value at time zero
δt: length of period
s: stock price process
B: bond price process, B0 = 1
Q: measure made up of the qs
X: claim payoff
T : time of claim payoff

Black-Scholes formula - (European call option)

" + #
√ σ2
V = EQ S0 exp(σ T Z − T ) − k exp(−rT )
2
2
! !
σ2
log(S0 /k) + (r + σ2 )T log(S0 /k) + (r − )T
= S0 Φ √ − ke−rT Φ √ 2
σ T σ T

Itô’s Lemma
If X is a stochastic process, satisfying

dXt = σt dWt + µt dt

and f is a deterministic twice continuously differentiable function, then Yt = f (Xt ) is also a

stochastic process and is given by
 
0 0 1 2 00
dYt = (σt f (Xt )) dWt + µt f (Xt ) + σt f (Xt ) dt.
2