Value of an American put - no dividends

Given So = 100, u = 1.1752, d=.8857 k=110,

r=.06, h=1/2, T=1

Find Po: the value of an American put at t = 0

uSo = 117.52 u2So = 138.11

100 Stock Lattice

K=110
104.09 = udSo

dSo = 88.57

d2So = 78.45

q puu = 0
pu
q 1-q
1
po
European Put Lattice
pud = 5.91
1-q
2
q
pd
1-q
pdd = 31.55

q = erh - d = e(0.06)1/2 - 0.8857 = 0.5

u-d 1.1752 - 0.8857

pu = e-rh [q puu + (1 - q) pud] = e-(0.03) [(.5)(5.91) = 2.87

pd = e-rh [q pud + (1 - q) pdd] =e-(0.03) [(.5)(5.91) + (.5)(31.55)] = 18.18

At Node 1:

Pu = K - uSo = 110 - 117.52 <0 do not exercise

pu = 2.87  pu > Pu

At Node 2:

Pd = K-dSo, = 110 - 88.57 = 21.43

and pd = 18.18

Now Pd > pd  exercise

Now put Lattice is:

pu = 2.87 po = e-(.03) [q(2.87) + (1 - q)(21.43)]

q
= 11.79
1
Po Also
don't
1-q 2 Po = K - So = 10 exercise

pd = 21.43

 Po = 11.79
 Pu = 2.87 Puu = 0

Po = 11.79
pud = 5.91

Pd = 21.43

EXERCISE pdd = 31.55

 No replicating portfolio

Replicating portfolios: Po = o So + Bo

o = Pu - P d = 2.87 - 21.43 = -0.64 (short .64 of stock)

(u - d)So= 117.52 - 88.57

Bo = Po - oSo= 11.79 + (.64)(100)

= 75.79

At node 2, put has been exercised pud

∴ no replicating portfolio pd pdd

At node 1, replicating portfolio determined by u1, Bu1

u1 = Puu – Pud = 0 – 5.91

(u2 – ud)So 138.11 – 104.09

= - 0.17

Bu1 = Pu - u1 (u So)

= 2.87 – (-0.17) (117.52)

= 22.85

Replicating portfolios are:

For 0 ≤ t ≤ ½ : o S o + B o = - 0.64 So + 75.79

For ½ ≤ t ≤ 1 : upstate only

u1 (u So) + Bu1 = (-0.17)(117.52) + 22.85

= - 0.17 (uSo) + 22.85

At node 1 o u1 and Bo Bu1

American Call with dividends

Example:

So=100, K=90, T=1, r=0.06 u=1.1752, d=0.8857

$5 dividend at t=1/2

Take h = ½ i.e. 2 period BOPM

Recall: American call with no dividends=do not exercise early (i.e. its equivalent to a
European call)

t=1/2 means just before dividend date at t=1/2

uSo = 117.52, div of $5 => uSo –div =

112.52
So = 100

t=0
dSo = 88.57, div of $5 => dSo –div = 83.57
t = 1/2

Upstate at t = ½ :

u(uSo – div = 132.23 Cuu = 42.23

uSo – div = K = 90
112.52

t=½
d(uSo – div) = 99.65 Cud = 9.65

t=1

downstate at t = ½ :
 u(dSo – div = 98.21 Cdu = 8.21

dSo – div = 83.57 K = 90

t=½
d(dSo – div) = 74.01 Cdd = 0

t=1

upstate at t = ½ :

Cuu = 42.23
q

cu
1

1-q
Cud = 9.65

q = erh – d = e(0.06)1/2 - .8857 = 0.5

u–d 1.1752 - .8857

cu1 = e-rh [qcuu + (1 - q) cud]

=> cu1 = 0.9705 [ (.5)(42.23) + (.5)(9.65)]

= 25.17
 Downstate at t = ½ :

Cdu = 8.21
q

Cd1

1-q
Cdd = 0

Cd1 = 0.9705 [(.5)(8.21) + (.5)(0) ]

= 3.98

42.23
Cu1 = 25.17
European Call Lattice
Co = ?
9.65

8.21
Cd1 = 3.98

0
At node Cu1: not exercised cu1 = 25.17

If exercised cu1 = uSo – K = 117.52 – 90 = 27.52

Just before div date

∴ exercise and cu1 = 27.52

At node Cd1: not exercised cd1 = 3.98

If exercised just before div date cd1 = max(dSo – K, 0)

= max (88.37 – 90, 0) = 0

->Don’t exercise:

American call lattice now is:

Cu1 = 27.52

Co =?

t=0

Cd1 = 3.98
t=½

Now Co = 0.9705 [½ (27.52) + ½ (3.98)] = 15.28

Also if exercised at t = 0: Co = max (So – k, 0) = 10

Don’t exercise

∴ Co = 15.28
Replicating Portfolios

0 ≤ t ≤ ½: co = o So + Bo

o = cu1 – cd1 = 27.52 – 3.98 = 0.8131 (long)

(u – d)So 117.52 – 88.57

Bo = Co - o So = 15.28 – 100 (.8131) = -66.03 (borrow)

½ ≤ t ≤ 1: in up-state call has been exercised

∴ replicating portfolio not relevant

In downstate: cd1 = d1 (dSo – div) + Bd1

d1 = cdu – cdd = 8.21 – 0

(u – d) (dSo – div) (1.1752 - .8857)(88.57 – 5)

=0.3392

Bd1 = cd1 - d1 (dSo – div)

= 3.98 – (.3392) (83.57)

= -24.37