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INTRODUCTION TO BINOMIAL MODELS

Numerical Methods in Finance (Implementing Market Models)

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Agenda
Page

1
Introduction to Binomial Model 1

3
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Lecture Objectives
 Binomial Models
 Understand simple 1-step binomial models
 Price an option using a 1-step binomial model
 Understand multiplicative binomial process
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Binomial Models
 American options on a non-dividend asset are never
exercised early, so they can be valued using the
Black-Scholes Formula

 But, it can be optional to early exercise American

calls and puts where the underlying asset pays a
dividend

 There are no closed-form solutions to these options,

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we must use numerical techniques

 E.g. Binomial Trees

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 Binomial Models assume that the underlying asset
follows a binomial process

 At any time, the asset price can change to one of two

possible values

 The asset price follows a binomial distribution

 E.g. Binomial Trees

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The asset price starts
on the left and takes
one of two steps as
time moves forward
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 Turn on the side and notice the binomial distribution
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 Compare with a Gaussian Distribution
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 Consider an asset with a current price S which follows a
binomial process

 During a time period Δt, the asset price can go up to uS

or down to dS uS

S
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dS

Δt

 This is known as a Multiplicative Binomial Process

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 Now, consider a call option on this asset at the same
nodes

 Recall again that the value of a European call option at

its expiration is given by
cT = max( ST − K ,0 )
uS
Cu = max(uS-K,0)
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S
C

dS
Cd = max(dS-K,0)
Δt
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Binomial Models
 We construct a portfolio at t=0, such that at maturity
(t=T), the value of the portfolio will be the same
whether the asset price goes to uS or dS

 Let the portfolio consist of a short position in the call

option and a long position in Δ units of the asset

 Portfolio = ΔS – C at t=0

 At maturity (t=T) the portfolio is worth

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 ΔuS – Cu or ΔdS – Cd
Cu − C d
 Rearranging, we have ∆= Eq 2.1.1
(u − d ) S
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 As the portfolio is riskless, it must grow at the risk free
rate of interest, therefore
e r∆t ( ∆S − C ) = ∆uS − Cu = ∆dS − Cd Eq 2.1.2

 Where r is the risk free rate of interest

 Now, combining Eq 2.1.1 and Eq 2.1.2 we have

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C = e − r∆t [ pCu + (1 − p ) Cd ]
 where
e r∆t − d
p=
u−d
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 Jump to 2-step and then n-step
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 Now, we need to work with Binomial Trees using
mathematical software. It helps to visualise how we can
fit the tree into a matrix
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 We have transformed the tree into a ½ matrix

 Continuing this process, add nodes

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 MS Excel isn’t powerful enough but we can use it for
testing purposes. Examine the example below;
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 In the last slide, we saw how we can use a generic Excel
reference array to calculate any value of the tree.

 Excel isn’t scalable. We might need to include thousands

of nodes and these will get more complicated as we
shall see.

 We use a programming language such as MatLab

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Recommended Texts
 Required/Recommended
 Clewlow, L. and Strickland, C. (1996) Implementing derivative
models, 1st ed., John Wiley and Sons Ltd.
— Chapter 2

 Additional/Useful
 Hull, J. (2009) Options, futures and other derivatives, 7th ed.,
Prentice Hall
— Chapters 11
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