Lecture 1: The Tree Approach I -- Binomial Branch

Framework

• Framework: a risky stock St, a riskless cash bond Dt, and a derivative Ft.

p su
The stock price starts at s0 ( S0 = s0). A short tick
St s0
later ( Δt ), the stock price can jump up to su ( SΔt =
1-p sd
su) with probability p and jump down to sd ( SΔt = sd)
t=0 t= Δt with probability (1-p).

The bond price is not random. Let r be the

continuously compounded risk-free rate. If the
r Δt initial price of a cash bond is D0 =1, then a short
Dt 1 e
tick later, the bond price will grow to
rΔt r Δt
DΔt = D0 e = e with probability 1 no matter
t=0 t= Δt
the stock price goes up or down.

p fu A derivative pays off fu if the stock price goes up

Ft f0?? and fd if the stock price goes down.
1-p fd

t=0 t= Δt
(Capital letters represent random variables and lower cases represent realizations.)

• Question: What is the initial price of the derivative?

ƒ The unconscious statistician might pay f 0 = e − r Δt ( pf u + (1 − p) f d ) , i.e. the

expectation of future payoffs discounted by the risk-free rate.

ƒ But, this answer is wrong! Why?

• The relationship between a derivative and its underlying is the same no matter
which discount factor we use, as long as we use the consistent probability
measure.
ƒ the appropriate discount rate μ and the true probability p
f 0 = e − μΔt ( pf u + (1 − p ) f d )
the appropriate discount rate --- very difficult to determine
the true probability p --- often not observable;
MFIN7003: Mathematical Techniques in Finance _ Dr. Rujing Meng

ƒ the risk-free discount rate r and the risk-neutral probability q

f 0 = e − r Δt ( qfu + (1 − q) f d )
the risk-free discount rate --- observable;
the risk-neutral probability --- easy to calculate. How?

No-arbitrage

• Definition of Arbitrage: The simultaneous buying and selling of a security at two

different prices in two different markets, resulting in profits without risk.
Perfectly efficient markets present no arbitrage opportunities. Perfectly efficient
markets seldom exist, but, arbitrage opportunities are often precluded because of
transactions costs. 1

• Axiom: There is no arbitrage opportunity in financial markets.

Based on this principle, we have the following law:

• The Law of One Price: If two securities have the same payoffs in the future, then
they must have the same price today.

Otherwise, arbitrage opportunity exists.

• Definition of Arbitrageur: One who profits from the difference in price when the
same, or extremely similar, security, currency, or commodity is traded on two or
more markets. The arbitrageur profits by simultaneously purchasing and selling
these securities to take advantage of pricing differentials (spreads) created by
market conditions.

Risk-neutral Probability & Replicating Portfolio

• Let us find the risk-neutral probability by applying the law of one price.

• We construct a portfolio out of the stock and the cash bond to mimic the payoffs
of the derivative. This portfolio is called “replicating portfolio.” Then the price of
the derivative must be the same as the price of the replicating portfolio by the law
of one price.

• Let x be the stock holding strategy and let y be the bond holding strategy. The
unit of x and y is number of shares. Then the price and the payoffs of the
portfolio are as shown in the following diagram:

1
The New York Times Dictionary of Money and Investing: The Essential A-to-Z Guide to the Language of
the New Market by Gretchen Morgenson and Campbell R. Harvey

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MFIN7003: Mathematical Techniques in Finance _ Dr. Rujing Meng

rΔt
p xsu + y e
xs0 + y
1-p
rΔt
xsd + y e

fu
p
f0 ??
1-p
fd

t=0 t= Δt

⎪⎧ xsu + ye = fu
r Δt

• Solve liner equation system ⎨ r Δt

for x and y, we have
⎪⎩ xsd + ye = f d
⎧ fu − f d
⎪x = s − s
⎪ u d
⎨ (1)
⎪ y = e− r Δt f d su − f u sd
⎪⎩ su − sd

• Substitute the above into xs0 + y ( D0 = 1 ), we have the price of the portfolio:
⎛ e r Δt s0 − sd s − e r Δt s0 ⎞
xs0 + y = e− r Δt ⎜ fu + u fd ⎟
⎝ su − sd su − sd ⎠
⎛ e s0 − sd
r Δt
⎛ e s0 − sd ⎞ ⎞
r Δt
= e − r Δt ⎜⎜ fu + ⎜1 − ⎟ f d ⎟⎟
⎝ s u − s d ⎝ s u − s d ⎠ ⎠

• By the law of one price, this must also be the price of the derivative otherwise
there exists an arbitrage opportunity.
⎛ e r Δt s0 − sd ⎛ e r Δt s0 − sd ⎞ ⎞
f 0 = xs0 + y = e − r Δt ⎜⎜ fu + ⎜1 − ⎟ f d ⎟⎟
⎝ s u − sd ⎝ s u − s d ⎠ ⎠
• The above procedure implies several points:
f − fd
ƒ To construct a replicating portfolio, we should buy x = u shares of
su − sd
the stock according to formula (1).

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MFIN7003: Mathematical Techniques in Finance _ Dr. Rujing Meng

ƒ The formula f 0 = xs0 + y implies that the strategy that long 1 share of the
derivative and short x shares of the stock will result in a risk-free
investment. The x here is so called “hedge ratio.”

e r Δt s0 − sd
ƒ Let q = , then
su − sd
f 0 = e − r Δt ( qf u + (1 − q ) f d ) (2)

Pricing formula (2) looks like what we want --- the price of the derivative
is the expectation of the future payoffs discounted at the risk-free rate!

Is q the risk-neutral probability we are looking for?

It is if it satisfies the property of probability. That is whether 0 ≤ q ≤ 1 .

It turns out YES! (Check it yourself. Hint: using no-arbitrage theory.)

• So, q is the “risk-neutral probability.” A collection of risk-neutral probabilities

{ q , 1 − q } on the set of all possible outcomes {up, down} is called risk-neutral
probability measure or simply risk-neutral measure, denoted by Q .

• The price of the derivative is the expected future payoffs under the risk-neutral
measure Q discounted by the risk-free rate.
f 0 = e − r Δt ( qf u + (1 − q ) f d )

• Note, q depends only on the risk-free rate r, current stock price s0 and the future
possible stock prices su and sd. It does not depend on the true probability p at all!

• So the price of the derivative does not depend on the true probability p at all!

Martingale

• Definition of Martingale: A process X t is a martingale with respect to a measure

Ρ if it satisfies the following two conditions,
(i) E P ( X T | X t ,..., X 0 ) = X t , for all T > t , and
(ii) E P ( | X T |) < ∞, for all T .

• The second condition (ii) is merely a technical condition. It is the first one (i) that
carries the central meaning of the martingale.

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MFIN7003: Mathematical Techniques in Finance _ Dr. Rujing Meng

• Definition of Martingale Measure: A martingale measure of a process is the

measure that makes the process a martingale.

• The risk-free discounted stock price is a martingale under the risk-neutral measure
Q.

• The risk-free discounted derivative is a martingale under the risk-neutral measure

Q.

• So the risk-neutral measure Q is also called “equivalent martingale measure.”

• Uniqueness and Existence of the measure Q : in discrete-time world, for any

sensible stock process, there will be a unique measure Q under which the
discounted stock is a Q -martingale.

• How to find the measure Q . Remember it is the measure that makes the risk-free
discounted stock price a martingale.

• In the binomial tree approach, the tree structure is given. If we can find a measure
Q that makes the risk-free discounted stock price process a martingale, then the
risk-free discounted derivative will also be a Q -martingale. The price of the
derivative today, therefore, is the expected discounted future payoffs at the risk-
free rate under Q -measure.

q
e−rΔt su
s0 = qe− rΔt su + (1 − q ) e− rΔt sd

e−rΔtsd
1-q

q
e−rΔt fu
f0 = qe− rΔt fu + (1 − q ) e− rΔt f d

e−rΔt fd
1-q

t=0 t= Δt

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MFIN7003: Mathematical Techniques in Finance _ Dr. Rujing Meng

Let s0 = qe− rΔt su + (1 − q ) e− rΔt sd , then we can solve for q as

e r Δt s0 − sd
q=
su − sd

Summary: 5-step risk-neutral derivative pricing rule in the binomial branch

framework

Step 1: Discount the stock price, S Δt , by using risk-free rate to have

− r Δt
discounted stock price, e S Δt ;

Step 2: Find a measure Q that makes the discounted stock price a martingale:
S0 = e − r *0 S0 = E Q ( e − r Δt S Δt ) ;
or specifically,
s0 = qe− rΔt su + (1 − q ) e− rΔt sd
e r Δt s0 − sd
⇒q=
su − sd

Step 3: Discount the derivative price, FΔt , by using risk-free rate to have
− r Δt
discounted derivative price, e FΔt ;

Step 4: Calculate the expectation of the discounted derivative price under measure
Q. This expectation is the price of the derivative;
f 0 = qe − r Δ t f u + (1 − q ) e − r Δ t f d
= e − r Δ t ( qf u + (1 − q ) f d )

Step 5: Calculate hedge ratio. To mimic payoffs of the derivative, we construct a

f − fd
replicating portfolio by long x = u shares of the stock and make up the
su − sd
balance of the price of the derivative by riskless borrowing or lending.

• An example.

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MFIN7003: Mathematical Techniques in Finance _ Dr. Rujing Meng

S0=100
D0=1
r=0.05 Solution:
dt=1/12 Step1: The discounted stock price process
108.5929
stock price process 100
109.0463 with p=0.5 91.32285
100
91.70415 Step 2: We know the true probability p is irrelevant when pricing
derivatives. We need to solve for a measure Q that makes the
discounted stock price process a martingale:
A derivative 100=108.5929*q+91.32285*(1-q)
10 q= 0.502439
??
8.5
Step 3: The discounted payoffs of the derivative
9.95842
f0
8.464657
Step4: The expectation of the discounted payoffs of the
derivative under measure Q is the price of the derivative
f0=9.95842*q+8.464657*(1-q)= 9.215182

Step 5: Hedge Ratio

Stock shares holding x=(fu-fd)/(Su-Sd)= 0.086494
Bond shares holding y=(f0-x*S0)/D0= 0.565744

Verify whether the portfolio generates the same payoffs as

the derivative
"up": x*Su+y*EXP(rdt)= 10 = fu ! verified.
"down": x*Sd+y*EXP(rdt)= 8.5 = fd ! verified.