6

The Cox-Ross-Rubinstein model

In this chapter we examine in detail a simple class of discrete-time binary models with one stock and one bond.
These are known as Cox-Rox-Rubinstein models (named after the authors who first introduced them), and have been
widely studied and used. The key feature of a Cox-Ross-Rubinstein model is that all nodes look the same—this makes
certain calculations relatively easy. Cox-Ross-Rubinstein models are also important because in a well-defined sense
the famous Black-Scholes continuous-time market model is a limit of suitably scaled Cox-Ross-Rubinstein models.

6.1 Description and basic properties

A Cox-Ross-Rubinstein model with T ∈ N time steps is a discrete-time model consisting of one bond with initial
price 1 and fixed interest rate r > −1, together with a single stock with initial price S0 > 0. Branching on the
price tree is binary, and is completely determined by two parameters, denoted by u > −1 (“up”) and d ∈ (−1, u)
(“down”). At each node λ, at time t = 0, . . . , T − 1, if the current price of the stock is St (λ), then the stock prices
at the two successor nodes at time t + 1 are St (λ)(1 + u) and St (λ)(1 + d), respectively. In addition, there may be
some probabilities associated with the stock price movement, but, since real-world probabilities are not relevant to our
pricing theory, it is common practice to simply omit them.
Thus the whole model is specified by the parameters T , r, S0 , u and d. There may also be some real-world
probabilities associated with the movement of prices but as we have seen, they are not relevant in the context of
derivative pricing. We will make frequent use of the derived parameters

U := 1 + u, R := 1 + r, D := 1 + d.

Example 6.1
Model 6.1 is a three-step Cox-Ross-Rubinstein model. Note that at each time there are several nodes with the same
current price. For example, at time 3 there are three nodes with the same price S0 U 2 D, and they are associated with
the price histories

S0 , S0 U, S0 U 2 , S0 U 2 D , S0 , S0 U, S0 U D, S0 U 2 D , S0 , S0 D, S0 U D, S0 U 2 D ,




6.1 Description and basic properties 6. The Cox-Ross-Rubinstein model

S0 U 3
2
S0 U
S0 U 2 D
S0 U
S0 U 2 D
S0 U D
S0 U D 2
S0
S0 U 2 D
S0 U D
S0 U D 2
S0 D
S0 U D 2
2
S0 D
S0 D 3

Model 6.1: Three-step Cox-Ross-Rubinstein model

respectively. Since a node is defined by the whole price history up to that node, these nodes are clearly different. A
Cox-Ross-Rubinstein model such as this is often pictured as in Figure 6.1. However care should be taken when using
this type of representation, because it places several nodes all at the same place on the diagram.

S0 U 3
2
S0 U
S0 U S0 U 2 D
S0 S0 U D
S0 D S0 U D 2
2
S0 D
S0 D 3

Figure 6.1 Three-step Cox-Ross-Rubinstein model

The set Ωt of nodes in a Cox-Ross-Rubinstein model at time t can be identified with the collection of all sequences
of length t consisting of u’s (indicating an “upwards” movement of the stock price) and d’s (indicating a “downwards”
movement of the stock price). Thus the model has 2t nodes at any time t, and 2T scenarios in total.
The 2t nodes at any time t in a Cox-Ross-Rubinstein model result in only t + 1 different stock prices at time t. In
ascending order, these prices are
S0 Dt , S0 U Dt−1 , S0 U 2 Dt−2 , . . . , S0 U t .
The number of nodes in the graphical representation of a Cox-Ross-Rubinstein model therefore does not correspond
to the number of distinct time-t prices in its stock price tree—as we have seen in Section 4.2, a node in the stock price
tree is determined by the entire price history up to that point, not just the final price. In general, there may be more than
one node with the same terminal price—we refer to this property by saying that the stock price tree is recombinant, or
that the stock price evolves in a recombining fashion.

112
6. The Cox-Ross-Rubinstein model 6.2 Viability and completeness

6.2 Viability and completeness

The theory that we developed in Chapters 3 and 4 for discrete-time models is directly applicable to the Cox-Ross-
Rubinstein model. Let us first consider the viability of this model.

Theorem 6.2
A Cox-Ross-Rubinstein model is viable if and only if d < r < u.

Proof
We know from Theorems 4.11 and 3.35 that a single-stock model such as this is viable if and only if

min { St+1 (µ)| µ ∈ succ λ} < (1 + r)St (λ) < max { St+1 (µ)| µ ∈ succ λ}

at every node λ, at every non-terminal time t = 0, . . . , T − 1. In a Cox-Ross-Rubinstein model, every such node λ has
two successor nodes λu and λd, and the stock prices on these nodes are, respectively

St+1 (λu) = St (λ)U,St+1 (λd) = St (λ)D.

Since D < U , the Cox-Ross-Rubinstein model is viable if and only if

St (λ)D < St (λ)R < St (λ)U,

if and only if D < R < U., if and only if d < r < u.

The previous result agrees with the idea that a Cox-Ross-Rubinstein model is simply a sequence of single-step
binary models that all behave in the same way. Again drawing on the general theory, we now obtain the following
description of the equivalent martingale measure in a Cox-Ross-Rubinstein model.

Theorem 6.3
If a Cox-Ross-Rubinstein model is viable, then it admits a unique equivalent martingale measure Q. The one-step
conditional risk-neutral probabilities at every non-terminal node λ are
   
R−D U −R r−d u−r
(qλu , qλd ) = (q, 1 − q) := , = , .
U −D U −D u−d u−d
For every ω ∈ Ω, if
ST (ω) = S0 U s DT −s
for some s = 0, . . . , T , then
Q(ω) = q s (1 − q)T −s .
Thus Q(ω) depends only on ST (ω) and not the full price history of ω.

Proof
The risk-neutral probability (qλu , qλd ) at any node λ at time t = 0, . . . , T − 1 satisfies

qλu St+1 (λu) + qλd St+1 (λd) = [1 + r]St (λ), qλu + qλd = 1,

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6.2 Viability and completeness 6. The Cox-Ross-Rubinstein model

i.e.
qλu U + qλd D = R, qλu + qλd = 1,
from which it follows that
   
R−D U −R r−d u−r
(qλu , qλd ) == , = ,
U −D U −D u−d u−d
The formula for Q follows from Theorem 5.17; it is clear that if the final price ST (ω) is given for some scenario
ω ∈ Ω, then we can deduce from it the number of “up” jumps in the price history.

Example 6.4
Model 6.2 contains the Cox-Ross-Rubinstein model with parameters T = 2, r = 0.1, S0 = 100, u = 0.2 and
d = −0.1. The one-step conditional risk-neutral probabilities are simply

S2 (uu) = 144
S1 (u) = 120
S2 (ud) = 108
S0 = 100
S2 (du) = 108
S1 (d) = 90
S2 (dd) = 81

Model 6.2: Cox-Ross-Rubinstein model with T = 2, r = 0.1, S0 = 100, u = 0.2, d = −0.1

   
0.1 + 0.1 0.2 − 0.1 2 1
(q, 1 − q) = , = , .
0.2 + 0.1 0.2 + 0.1 3 3
It is now a simple matter to find an equivalent martingale measure Q for this model. Indeed,
4 2 2 1
Q(uu) = q 2 = , Q(ud) = q(1 − q) = , Q(du) = q(1 − q) = , Q(dd) = (1 − q)2 = .
9 9 9 9

For any s = 0, . . . , T , we may use simple combinatorices to deduce that there are Ts = s!(TT−s)!!


different
scenarios consisting of s “up” jumps and T − s “down” jumps, each having the same risk-neutral probability q s (1 −
q)T −s . Consequently,  
s T −s T s
q (1 − q)T −s .


Q ω ∈ Ω ST (ω) = S0 U D = (6.1)
s
Since the Cox-Ross-Rubinstein model has binary branching at each node, it is complete, and therefore every
derivative security in this model may be priced using the theory we developed in Chapters 3–4. We have the following
result.

Theorem 6.5
Every viable Cox-Ross-Rubinstein model is complete, and the fair price πt at any time t = 0, . . . , T of any derivative
security with payoff D at time T is given by
πt = VtΦ = Rt EQ D̄ Ft .

where Φ is the unique replicating strategy for D and Q is the unique equivalent martingale measure given in Theorem
6.3.

114
6. The Cox-Ross-Rubinstein model 6.2 Viability and completeness

Proof
This is a direct application of Theorems 4.19, 5.32 and 5.37.

It is sometimes useful to express the Cox-Ross-Rubinstein model in terms of the returns on the stock, rather than
the stock price itself. If we define the random variables R1 , . . . , RT by
St
Rt :=
St−1
for t = 1, . . . , T, then
t
Y
St = S0 Rs (6.2)
s=1

for t = 1, . . . , T. If Q is the equivalent martingale measure in this model, then

EQ ( Rt+1 | Ft ) = R (6.3)

for t = 0, . . . , T − 1. Indeed, we have

EQ S̄t+1 Ft = S̄t ,
i.e.
EQ ( St+1 | Ft ) = RSt .
As St is Ft -measurable, it follows that  
St+1
EQ Ft = R,
St
which is equivalent to (6.3). We moreover have the following result.

Theorem 6.6
In a Cox-Ross-Rubinstein model with equivalent martingale measure Q, the random variables R1 , . . . , RT are inde-
pendent and identically distributed with

Q ({ω ∈ Ω |R1 (ω) = U }) = q, Q ({ω ∈ Ω |R1 (ω) = D }) = 1 − q,

where
R−D
q= .
U −D

Proof
For t = 1, . . . , T , the random variable Rt takes its value in the set {D, U }. Moreover, it follows from Theorem 6.3
and the Ft -measurability of Rt that
   
[ [ X
Q ({ω ∈ Ω |Rt (ω) = U }) = Q  {ω ∈ λ |Rt (ω) = U } = Q  λu = Q (λu) ,
λ∈Ωt−1 λ∈Ωt−1 λ∈Ωt−1

so that
X X X
Q ({ω ∈ Ω |Rt (ω) = U }) = Q (λu|λ) Q (λ) = qλu Q (λ) = q Q (λ) = q.
λ∈Ωt−1 λ∈Ωt−1 λ∈Ωt−1

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6.3 The Cox-Ross-Rubinstein formula 6. The Cox-Ross-Rubinstein model

We moreover have

Q ({ω ∈ Ω |Rt (ω) = D }) = 1 − Q ({ω ∈ Ω |Rt (ω) = U }) = 1 − q.

Therefore R1 , . . . , RT are identically distributed with the stated distribution.

The independence of R1 , . . . , RT may be proved by induction. For t = 1, . . . , T − 1, suppose that R1 , . . . , Rt are
independent of each other, i.e. for any sequence x1 , x2 , . . . , xt in {U, D}, we have
t
! t
\ Y
Q {ω ∈ Ω |Rs (ω) = xs } = Q ({ω ∈ Ω |Rs (ω) = xs }) .
s=1 s=1

It follows that
" t # !
\
Q {ω ∈ Ω |Rs (ω) = xs } ∩ {ω ∈ Ω |Rt+1 (ω) = U }
s=1
t
! t
!
\ \
= Q {ω ∈ Ω |Rt+1 = U } {ω ∈ Ω |Rs (ω) = xs } Q {ω ∈ Ω |Rs (ω) = xs }
s=1 s=1
t
! t
\ Y
= Q {ω ∈ Ω |St+1 (ω) = U St (ω) } {ω ∈ Ω |Ss (ω) = xs Ss−1 (ω) } Q ({ω ∈ Ω |Rs (ω) = xs })
s=1 s=1
t
Y
=q Q ({ω ∈ Ω |Rs (ω) = xs })
s=1
t
Y
= Q ({ω ∈ Ω |Rt+1 (ω) = U }) Q ({ω ∈ Ω |Rs (ω) = xs }) .
s=1

In similar fashion, we obtain

" t # !
\
Q {ω ∈ Ω |Rs (ω) = xs } ∩ {ω ∈ Ω |Rt+1 (ω) = D }
s=1
t
Y
= Q ({ω ∈ Ω |Rt+1 (ω) = D }) Q ({ω ∈ Ω |Rs (ω) = xs }) .
s=1

Thus the random variables R1 , . . . , Rt+1 are also independent.

6.3 The Cox-Ross-Rubinstein formula

Formulating the Cox-Ross-Rubinstein model in terms of returns on the stock allows us to give a general formula for
the calculation of the fair price of a European call option. This is known as the Cox-Ross-Rubinstein formula.
Let π0C be the fair price at time 0 of a European call option with strike K and exercise date T in a viable Cox-
Ross-Rubinstein model with equivalent martingale measure Q. Combining Theorem 6.5 and equation (6.1), we obtain
T  
1 1 X T s
π0C = T EQ [ST − K]+ = T q (1 − q)T −s S0 U s DT −s − K + .

 
R R s=0 s

This is not an easy formula to evaluate, especially if T is large. However, since U > D, the stock price S0 U s DT −s in
the above summation increases as s increases. If we therefore let

A := min s ∈ {0, . . . , T } S0 U s DT −s > K ,



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6. The Cox-Ross-Rubinstein model 6.3 The Cox-Ross-Rubinstein formula

then
T  
1 X T s
π0C = q (1 − q)T −s S0 U s DT −s − K
 
R T s
s=A
T   T  
S0 X T s T −s s T −s K X T s
= T q (1 − q) U D − T q (1 − q)T −s
R s R s
s=A s=A
T   s  T −s T  
X T U D K X T s
= S0 q (1 − q) − T q (1 − q)T −s . (6.4)
s R R R s
s=A s=A

In order to simplify this expression further, we need to recall the definition of the binomial distribution. A binomial
random variable is defined as the number of successes in n ∈ N trials, where each trial is independent of the others,
and has two possible outcomes (success and failure), where the probability of a success is p ∈ [0, 1]. By means of a
simple counting argument, it follows that the probability that a binomial random variable with parameters n and p is
equal to k = 0, . . . , n is given by  
n k
b(k; n, p) := p (1 − p)n−k .
k
Consequently, the probability of having at most k = 0, . . . , n successes is given by the binomial distribution function
k k  
X X n l
B(k; n, p) := b(l; n, p) = p (1 − p)n−l .
l
l=0 l=0

The complementary binomial distribution function gives the probability of at least k successes in n trials, and is
defined as n n  
X X n l
Ψ (k; n, p) := b(l; n, p) = p (1 − p)n−l = 1 − B(k − 1; n, p).
l
l=k l=k
Most spreadsheet programs such as Microsoft Excel have built-in functions to evaluate both b(k; n, p) and B(k; n, p)
so it is very easy to compute Ψ (k; n, p).
If we now put
U R−DU
q ′ := q = > 0,
D U −DR
then
R−DU R(U − D) − U (R − D) U −R U U
1 − q′ = 1 − = = = (1 − q) > 0.
U −DR R(U − D) U −DR R
Consequently, we may use (q ′ , 1 − q ′ ) as a new binary probability assignment, and equation (6.4) becomes
K
π0C = S0 Ψ (A; T, q ′ ) − Ψ (A; T, q) .
RT
We have therefore established the following result.

Theorem 6.7
In a viable Cox-Ross-Rubinstein model with parameters S0 , T , r, u and d the fair price at time 0 of a European call
option with expiry T and strike K is
K
π0C = S0 Ψ (A; T, q ′ ) − Ψ (A; T, q) , (6.5)
RT
where
A = min s ∈ {0, . . . , T } S0 U s DT −s > K


and
R−D U
q= , q′ = q .
U −D R

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6.3 The Cox-Ross-Rubinstein formula 6. The Cox-Ross-Rubinstein model

Exercise 6.1
Show that the fair price at time 0 of a European put option with expiry T and strike K in a viable Cox-Ross-
Rubinstein model is
K
π0P = T B (A − 1; T, q) − S0 B (A − 1; T, q ′ ) .
R
To use the Cox-Ross-Rubinstein formula, we need a convenient method for finding the critical number A. By
definition, we have
S0 U A−1 DT −A+1 ≤ K < S0 U A DT −A ,
which may be rearranged to yield
 A−1  A
U K U
≤ < .
D S0 D T D
Taking natural logarithms, it follows that
   
K U
A − 1 ≤ ln T
/ ln < A.
S0 D D
h i
In other words, to find A, it is only necessary to calculate ln S0KDT / ln D
U 
, and to find the smallest integer greater
than this number.

Example 6.8
Consider a Cox-Ross-Rubinstein model with parameters T = 10, S0 = 100, r = 0.02, u = 0.1, d = −0.1, together
with a European call option with strike K = 150. First of all, we have
       
K U 150 1.1
ln / ln = ln / ln ≈ 7.2710,
S0 D T D 100 × 0.9100 0.9
so that A = 8. Since
R−D 1.02 − 0.9 3 U 11 1.1 11
q= = = , q′ = q = × = ,
U −D 1.1 − 0.9 5 R 12 1.02 17
we have
K
π0C = S0 Ψ (A; T, q ′ ) − T Ψ (A; T, q)
 R  
11 150 3
= 100Ψ 8; 10, − Ψ 8; 10,
17 (1.02)10 5
10
X 10    s  10−s 10    s  10−s
11 6 150 X 10 3 2
= 100 − 10
≈ 4.9442.
s=8
s 17 17 (1.02) s=8 s 5 5

The price of a put option with the same expiry and strike is then
K 150
π0P = π0C − S0 + = 4.9442 − 100 + ≈ 27.9965.
RT (1.02)10

Exercise 6.2
Compute the fair price at time 0 of a straddle with payoff |S3 − 100| in the Cox-Ross-Rubinstein model with
parameters T = 3, r = 0.2, S0 = 100, u = 0.5 and d = 0.

118
6. The Cox-Ross-Rubinstein model 6.4 Convergence to the Black-Scholes formula

The arguments above may be generalised to find the fair price πtC at any time t < T by sinply thinking of any
node λ as the starting point of a Cox-Ross-Rubinstein model with T − t time steps and initial price St (λ). This leads
to the following general result.

Theorem 6.9
In a viable Cox-Ross-Rubinstein model with parameters S0 , T , r, u and d the fair price at time t = 0, . . . , T of
European call and put options with expiry T and strike K are given by
K
πtC = St Ψ (A; T − t, q ′ ) − Ψ (A; T − t, q) ,
RT −t
K
πtP = B (A − 1; T − t, q) − St B (A − 1; T − t, q ′ ) ,
RT −t
where
A ≡ At (St ) = min s ∈ {0, . . . , T − t} St U s DT −t−s > K


and
R−D U
q= , q′ = q .
U −D R

Remark 6.10
The value of A in this formula is different from the value of A in (6.5), as it depends both on t and on St .

Exercise 6.3
In a viable Cox-Ross-Rubinstein model, derive a formula for the fair price at time t = 0, . . . , T of a binary call
option with strike K whose payoff at time T is
(
1 if ST (ω) > K,
D(ω) =
0 if ST (ω) ≤ K.

6.4 Convergence to the Black-Scholes formula

In this section, we show that the Black-Scholes formulae for the prices of European call and put options in the
continuous-time Black-Scholes model can be obtained by passing to the continuous-time limit from the humble Cox-
Ross-Rubinstein model.
The Black-Scholes (or Black-Scholes-Merton) model is defined as a continuous-time market model over the time
interval [0, T ]. The price of the stock at time T is of the form

ST = S0 e[r− 2 σ ]T +σWT ,
1 2
(6.6)

where σ > 0 is the volatility of the stock, r ≥ 0 is the rate of continuous compounding (i.e. an investment of 1 in the
riskless asset is worth ert at time t ∈ [0, T ]) and the random variable WT is Gaussian with zero mean and variance T
with respect to a probability measure Q.
Consider now a sequence of viable Cox-Ross-Rubinstein models, all defined over a fixed time interval [0, T ] with
a common initial stock price S0 , but with an increasing number of steps within this interval, so that the time between

119
6.4 Convergence to the Black-Scholes formula 6. The Cox-Ross-Rubinstein model

T
trading dates decreases. Indeed, for n ∈ N, divide the interval [0, T ] into n steps of length n. The nth Cox-Ross-
Rubinstein model has n time steps, with riskless interest rate
T
rn := er n − 1. (6.7)

As we have seen in Theorem 6.2, this model is completely determined by a finite sequence R1n , . . . , Rnn of independent,
identically distributed random variables, each taking values in the set {Un , Dn } (to be specified shortly), so that the
price of the stock after t = 0, . . . , n steps is
Yt
Stn = S0 Rsn .
s=1
For simplicity, we assume that at each node the stock price is equally likely to jump

“up” or “down”, i.e. the one-step
conditionall probability assignment for each node is simply (q, 1 − q) = 21 , 21 . The probability Qn is then defined
accordingly.
It remains for us to choose the parameters Un and Dn ; as usual, we assume that Dn < Un . It is desirable to do this
in such a way that the probability Qn becomes the equivalent martingale measure for the nth Cox-Ross-Rubinstein
model. In order for the discounted stock price process to be a martingale with respect to Qn , we clearly need
1 1
1 + rn = Un + Dn . (6.8)
2 2
Moreover, by taking logarithms in (6.6), it turns out that
 
1
ln ST = ln S0 + r − σ 2 T + σWT ,
2
i.e. the random variable ln ST is Gaussian with mean ln S0 + r − 21 σ 2 T and variance σ 2 T . We intend to use a form
 

of the Central Limit Theorem to obtain the distribution of ln ST as a limiting distribution for the sequence (ln Snn )n∈N
of the natural logarithms of final stock prices. In doing so, we may simplify things greatly by stipulating the variance
in advance, by requiring that
varQn (ln Snn ) = σ 2 T
for n ∈ N. As
n
X
ln Snn = ln S0 + ln Rsn ,
s=1
it is sufficient to choose Un and Dn to satisfy
n
!
X
varQn ln Rsn = σ 2 T. (6.9)
s=1

For n ∈ N, we may now determine suitable values for Un and Dn from the conditions (6.8) and (6.9). First of all,
it can be easily verified that the variance of a random variable taking values in the set {a, b} ⊂ R, each with equal
probability, is equal to 14 |b − a|2 . Therefore
1
varQn (ln Rsn ) = (ln Un − ln Dn )2
4
for s = 1, . . . , n. From the independence of the sequence R1n , R2n , . . . , Rnn , it follows that
n
! n
n
X
n
X n 2
varQn (ln Sn ) = varQn ln Rs = varQn (ln Rsn ) = (ln Un − ln Dn ) .
s=1 s=1
4

The requirement in (6.9) therefore is that

n 2
[ln Un − ln Dn ] = σ 2 T,
4

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6. The Cox-Ross-Rubinstein model 6.4 Convergence to the Black-Scholes formula

i.e. r
T
ln Un − ln Dn = 2σ ,
n
i.e.
√T
Un = Dn e2σ n . (6.10)

Moreover, equations (6.7) and (6.8) yield

T
Un = 2er n − Dn . (6.11)

The system (6.10)–(6.11) may be solved to obtain

2 T 2 T
√T
Dn = √ T er n , Un = √ T er n +2σ n .
1 + e2σ n 1 + e2σ n

We can show further that the means associated with the sequence (ln Snn )n∈N converges the mean of ln ST , which
1 2

is ln S0 + r − 2 σ T . For n ∈ N we have
n
!
n
X
n n n
EQn (ln Sn ) = EQn ln S0 + ln Rs = ln S0 + [ln Un + ln Dn ] = ln S0 + ln (Un Dn ) . (6.12)
s=1
2 2

Moreover,
" T
√ T #2
n n 2er n +σ n
ln (Un Dn ) = ln √T
2 2 1 + e2σ n
√ !
σ T
T
rn 2e n
= n ln e √T
1 + e2σ n
" √T #
rT 1 + e2σ n
= n ln e n − ln √T
2eσ n
1 −σ√ T √ T i
 h
= rT − n ln e n + eσ n
2
" r #
T
= rT − n ln cosh σ . (6.13)
n

Using the Taylor expansion of the hyperbolic cosine function around 0, we obtain
" r #  
T 1 T 1
cosh σ = 1 + σ2 + o
n 2 n n2

for x ∈ R. We use the Landau symbol o to express the fact that that, if n is large, the contribution of the remainder of
the terms in the Taylor expansion is small in comparison to n12 . Likewise, by using the Taylor expansion of the natural
logarithm (which is a continuous function), we obtain
" r #     
T 1 T 1 1 2T 1
ln cosh σ = ln 1 + σ 2 + o 2
= σ + o .
n 2 n n 2 n n2

Returning to equation (6.13), we obtain

   
n 1 2 1
ln (Un Dn ) = r − σ T + o .
2 2 n

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6.4 Convergence to the Black-Scholes formula 6. The Cox-Ross-Rubinstein model

n


Consequently, the sequence 2 ln (Un Dn ) n∈N is convergent, so that
 
1
lim EQn (ln Snn ) = ln S0 + r − σ 2 T. (6.14)
n→∞ 2
We are now in a position to pass to the limiting distribution of the sequence (ln Snn )n∈N . The particular form of
the Central Limit Theorem that we require is for triangular arrays. Recall that for each n ∈ N we have a sequence
of n random variables R1n , R2n , . . . , Rnn that are independent and identically distributed. Taken together for all n, the
resulting sequence of the natural logarithms of these numbers form a triangular array, i.e.

ln R11 ,
ln R12 , ln R22 ,
ln R13 , ln R23 , ln R33 ,
..
.
ln R1n , ln R2n , . . . , ln Rnn ,

and so forth.

Definition 6.11 (Weak convergence)

A sequence (λn )n∈N of random variables converges weakly to a random variable λ if, for every bounded continuous
function g : R → R we have
lim EQn (g(λn )) = lim EQ (g(λ)) ,
n→∞ n→∞
where Q is the measure induced by the distribution of the random variable λ.

We present the followin result without proof.

Theorem 6.12 (Central Limit Theorem)

Suppose that (ξkn )n∈N,k≤n is a triangular array such that the sequence ξ1n , ξ2n , . . . , ξnn are independent and identically
distributed for each n ∈ N. Let
Xn
λn := ξkn
k=1
for n ∈ N. If

lim EQn (λn ) = µ, lim varQn (λn ) = ν 2 ,

n→∞ n→∞

then the sequence (λn )n∈N converges weakly to a Gaussian random variable with mean µ and variance ν 2 .

If we let ξkn := ln Rkn for n ∈ N and k ∈ {1, . . . , n}, then

Snn
 
λn = ln Snn − ln S0 = ln
S0
for n ∈ N. In view of (6.9) and (6.14), it follows that the sequence (ln Snn )n∈N converges weakly to a Gaussian
1 2
random variable with mean ln S0 + r − 2 σ T and variance σ 2 T . Since this is exactly the distribution of the Black-
 

Scholes stock price at time T , we say that the Cox-Ross-Rubinstein stock prices (ln Snn )n∈N converge weakly to the
Black-Scholes stock price ST .

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6. The Cox-Ross-Rubinstein model 6.4 Convergence to the Black-Scholes formula

Example 6.13
Suppose that S0 = 100, r = 10% and σ = 15% in a model with time horizon T = 1. Straightforward calculation
yields
σ2 0.152
 
ln S0 + r − T = ln 100 + 0.1 − ≈ 4.693920.
2 2
The expected logarithmic prices in (6.12) for different values of n in Table 6.1 suggests that convergence is very
fast. Figure 6.2 demonstrates that the probability mass functions of the Cox-Ross-Rubinstein stock prices also tend

n Un Rn Dn ln S0 + n2 ln(Un Dn )
1 1.269714 1.105171 0.940628 4.693962
2 1.162359 1.051271 0.940183 4.693941
4 1.102070 1.025315 0.948560 4.693931
8 1.066228 1.012579 0.958929 4.693925
16 1.043987 1.006270 0.968552 4.693923
32 1.029723 1.003130 0.976537 4.693922
64 1.020341 1.001564 0.982787 4.693921

Table 6.1 Parameters and expected logarithmic prices in Example 6.13

pointwise to the probability distribution function of the Black-Scholes stock price. Figure 6.3 shows the slightly tilted
stock price tree due to the exponential growth in the stock price.

0.5
1 step
2 steps
0.4 4 steps
8 steps
16 steps
32 steps
0.3 64 steps
Log-normal density

0.2

0.1

0
0 50 100 150 200 250 300 350 400
Stock price

Figure 6.2 Convergence of probability mass functions of Cox-Ross-Rubinstein stock prices in Example 6.1

To apply this weak convergence to our setting (the pricing of call and put options), we need to use a bounded
function; however, the payoff of a European call option is unbounded. Fortunately, the payoff of a European put option

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6.4 Convergence to the Black-Scholes formula 6. The Cox-Ross-Rubinstein model

300

250

200

150

100

50

0
0 0.2 0.4 0.6 0.8 1
Time

Figure 6.3 Stock price evolution in Cox-Ross-Rubinstein model with 32 steps in Example 6.1

with strike price K and exercise time T is bounded from above by K and from below by 0: we show that the Cox-
Ross-Rubinstein formula for the price of a put option converges to the formula for the put option in the Black-Scholes
model, and then use put-call parity to deduce the same result for call options. Indeed, for a fixed strike price K ≥ 0,
define the function g : R → [0, K] by
g(x) := [ex − K]− ;
if the stock price at time T is S, then the payoff of a European put option is simply g (ln S).
It follows from Theorem 6.5 that the fair price of a put option with exercise time n ∈ N and strike K in the nth
Cox-Ross-Rubinstein model is
1
P0n = EQ ([Snn − K]− ) = e−rT EQn (g (ln Snn )) .
(1 + rn )n n
The weak convergence of the sequence (ln Snn )n∈N to the Black-Scholes stock price therefore implies that
lim P0n = e−rT EQ (g (ln ST )) , (6.15)
n→∞

where Q is the probability measure induced by the distributions of WT and ln ST , both of which are of course Gaussian
random variables.
Our proof is complete except in one respect: we have not shown that the price of a put in the continuous-time
Black-Scholes model should be given by the expectation in (6.15). In fact, in similar fashion to the discrete-time case,
this follows from the fact that the Black-Scholes is complete, and that the probability measure Q is an equivalent
martingale measure for this model. A complete proof of this fact is outside the scope of the course; for our purposes,
it is sufficient to verify that the discounted expected value of a put option under the measure Q can be calculated
explicitly to yield the Black-Scholes formula for the price of a put option.
The random variable ln ST is Gaussian with mean ln S0 + r − 21 σ 2 T and variance σ 2 T . If we let

    
1 1 2
Z := √ ln ST − ln S0 + r − σ T ,
σ T 2
then the random variable Z is Gaussian with mean 0 and variance 1, and
√
ST = S0 e[r− 2 σ ]T +σ
1 2
TZ
.

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6. The Cox-Ross-Rubinstein model 6.4 Convergence to the Black-Scholes formula

The discounted expectation of the payoff of the put option in the Black-Scholes model can now be written explicitly
as
Z
1 h √ i
S0 e[r− 2 σ ]T +σ T x − K e− 2 x dx
1 2 1 2
−rT −rT
P0 := e EQ (g (ln ST )) = e √
2π −
ZR h √
1 − 12 σ2 T +σ T x
i 1 2
= √ S0 e −e −rT
K e− 2 x dx. (6.16)
2π R −

The integrand in (6.16) is zero unless √

1 2
T +σ T x
S0 e − 2 σ ≤ e−rT K.
Taking logs and rearranging, this inequality becomes
1 √ K
− σ 2 T + σ T x ≤ −rT + ln ,
2 S0
i.e.    
1 K 1
x ≤ γ := √ ln − r − σ2 T .
σ T S0 2
If we define N as the cumulative standard Gaussian distribution function, i.e.
Z z
1 1 2
N (z) := √ e− 2 x dx
2π −∞
for z ∈ R, then equation (6.16) becomes
Z γ h √
1 1 2
i 1 2
P0 = √ e−rT K − S0 e− 2 σ T +σ T x e− 2 x dx
2π −∞
Z γ Z γ √
K 1 2 S0 1 2 1 2
= e−rT √ e− 2 x dx − √ e− 2 σ T +σ T x− 2 x dx
2π −∞ 2π −∞
Z γ √ 2
S0
e− 2 [x−σ T ] dx
1
= e−rT KN (γ) − √
2π −∞
Z γ−σ√T
S0 1 2
=e −rT
KN (γ) − √ e− 2 y dy
2π −∞
−rT
 √ 
=e KN (γ) − S0 N γ − σ T .

In short, the limit of the sequence (P0n )n∈N of put option prices is therefore given by
 !  !
ln SK0 − r − 21 σ 2 T ln SK0 − r + 12 σ 2 T
 
−rT
P0 = e KN √ − S0 N √ ,
σ T σ T
which is of course the Black-Scholes formula for the price of a put option. It customary to rewrite it as

P0 = e−rT KN (−d2 ) − S0 N (−d1 ) ,

where
ln SK0 + r + 21 σ 2 T ln SK0 + r − 12 σ 2 T √
   
d1 = √ , d2 = √ = d1 − σ T .
σ T σ T
Finally, we are now in a position to demonstrate that the fair prices of call options in the sequence of Cox-Ross-
Rubinstein models converge to the Black-Scholes formula for the price of a call option. Indeed, for any n ∈ N, put-call
parity allows us to write the price of a call option with strike K and exercise date n as
K
C0n = P0n + S0 − = P0n + S0 − e−rT K.
(1 + rn )n

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6.4 Convergence to the Black-Scholes formula 6. The Cox-Ross-Rubinstein model

Since this is a continuous transformation, the convergence of (P0n )n∈N to P0 implies that (C0n )n∈N converges to

C0 := P0 + S0 − e−rT K.

As a result of the symmetry of the standard Gaussian distribution around 0, we obtain

C0 = S0 [1 − N (−d1 )] − e−rT K [1 − N (−d2 )] = S0 N (d1 ) − e−rT KN (d2 ) ,

as expected.

126