Introduction to Binomial

Trees
Chapter 12

12.1

A Simple Binomial Model

Note: Initial discussion is for options on assets that pay no income,
e.g. a non-dividend paying stock.

stock price is currently $20

In three months it will be either $22 or $18
Stock Price = $22
Stock price = $20
Stock Price = $18

12.2

A Call Option
A 3-month call option on the stock has a strike price of
21.
Stock Price = $22
Option Price = $1
Stock price = $20
Option Price=?

Stock Price = $18

Option Price = $0

12.3

Setting Up a Riskless Portfolio

Consider the Portfolio: long shares

Portfolio is riskless when 22 1 = 18 or

22 1

short 1 call option

= 0.25

18

12.4

Valuing the Portfolio

(Risk-Free Rate is 12%)
The

riskless portfolio is:

long 0.25 shares
short 1 call option
The value of the portfolio in 3 months is
22 0.25 1 = 4.50 = 18 0.25
The value of the portfolio today is
4.5e 0.120.25 = 4.3670
12.5

Valuing the Option

The

portfolio that is
long 0.25 shares
short 1 option
is worth 4.367
The value of the shares is
5.000 (= 0.25 20 )
The value of the option is therefore
0.633 (= 5.000 4.367 )
12.6

Generalization
A derivative lasts for time T and is
dependent on a stock
(Su is Sxu, Sd is Sxd versus subscripts u, d)

Su
u
Sd
d
12.7

Generalization
(continued)

Consider the portfolio that is long shares and short 1

derivative
Su u
Sd d

The portfolio is riskless when Su u = Sd d or

u f d

Su Sd
12.8

Significance of delta
If write one option (call or put) on one
share, delta is the number of shares you
must own to form a riskless portfolio.
Delta equals the (partial) derivative of the
option price with respect to the underlying
asset price.

Generalization
(continued)
Value

of the portfolio at time T is

Su u

Value

of the portfolio today is

(Su u )erT

Another

expression for the

portfolio value today is S f
Hence = S (Su u )erT
12.10

Generalization
(continued)
Substituting

for we obtain

= [ p u + (1 p )d ]erT

where (note: d < erT < u)

e d
p
ud
rT

12.11

Risk-Neutral Valuation

= [ p u + (1 p )d ]e-rT

The variables p and (1 p ) can be interpreted as the

risk-neutral probabilities of up and down movements
The value of a derivative is its expected payoff in a
risk-neutral world discounted at the risk-free rate

p
(1
p)

Su
u
Sd
d
12.12

Irrelevance of Stocks Expected

Return
When we are valuing an option in terms of
the underlying stock the expected return
on the stock is irrelevant.
The expected return on the stock provides
no information additional to S, the initial
value of the stock.
12.13

Implication of Risk-Neutrality
In a risk-neutral market, the expected total
return (comprised of the income
component and the capital gains
component) on any risk asset equals the
risk-free rate.

Original Example Revisited

p

(1
p)

Su = 22
u = 1
Sd = 18
d = 0

Since p is a risk-neutral probability

20e0.12
0.25 = 22p + 18(1 p ); p = 0.6523
Alternatively, we can use the formula
e rT d e 0.120.25 0.9
p

0.6523
ud
1.1 0.9

12.15

Valuing the Option

3
2
5
6
0.
0.34
77

Su = 22
u = 1
Sd = 18
d = 0

The value of the option is

e0.120.25 [0.65231 + 0.34770]
= 0.633
12.16

A Two-Step Example:
half year time horizon

24.2
22
19.8

20
18

16.2

Step=3

months, RNP constant

K=21, r=12%, u=1.1, d=.9
12.17

Valuing a European Call Option

D

22
20
1.2823

2.0257
18
0.0

B
E

24.2
3.2
19.8
0.0

C
F

16.2
0.0

Value at node B
= e0.120.25(0.65233.2 + 0.34770) = 2.0257
Value at node A
= e0.120.25(0.65232.0257 + 0.34770)
= 1.2823
12.18

A European Put Option Example

(2 year expiry)
K = 52, t = 1yr
r = 5% u=1.2 d=.8

60
50
4.1923

1.4147
40

72
0
48
4

9.4636

32
20

12.19

What Happens When an Put is

American (premature exercise at end
of 1st year if S=40)
D

60
50
5.0894

1.4147
40

72
0
48
4

12.0

32
20

12.20

Delta
Delta

() is the ratio of the change

in the price of a stock option to the
change in the price of the
underlying stock
The value of varies from node to
node: Dynamic (not static) hedging
is required
12.21

The Probability of an Up Move

What happens when the underlying asset is not a non-dividend
paying stock?

ad
ud
a e rt for a nondividend paying stock
p

a e ( r q ) t for a stock or stock index where q is the dividend

yield on the stock or stock index
ae

( r r f ) t

for a currency where rf is the foreign

risk - free rate

a 1 for a futures contract

12.22