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You are on page 1of 25

Trees

Chapter 12

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull 2013

A

In three months it will be either $22 or $18

Stock Price = $22

Stock price = $20

Stock Price = $18

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

A 3-month call option on the stock has a strike price of

21.

Up

Move

Option Price=?

Down

Move

Option Price = $1

Option Price = $0

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

option values are

Up

Move

is riskless when 22

2211 = 18

or = 0.25

Portfolio

Down

Move

18

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

(Risk-Free Rate is 12%)

The

long 0.25 shares

short 1 call option

The value of the portfolio in 3 months is

22 0.25 1 = 4.50

The value of the portfolio today is

4.5e 0.120.25 = 4.3670

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

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 )

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

A derivative lasts for time T and is

dependent on a stock

Up

Move

Su

u

Down

Move

Sd

d

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

Generalization (continued)

derivative:

Up

Move

S0u u

Down

Move

S0d d

u f d

S 0u S 0 d

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

Generalization

(continued)

Value

Su u

Value

(Su u )erT

Another

portfolio value today is S f

Hence = S (Su u )erT

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

Generalization

(continued)

= [ pu + (1 p)d ]erT

where

e rT d

p

ud

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

10

p as a Probability

of up and down movements

The value of a derivative is then its expected payoff in

discounted at the risk-free rate

S0

p

(1

p)

S0u

u

S0d

d

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

11

Risk-Neutral Valuation

When the probability of an up and down

movements are p and 1-p the expected stock

price at time T is S0erT

This shows that the stock price earns the riskfree rate

Binomial trees illustrate the general result that to

value a derivative we can assume that the

expected return on the underlying asset is the

risk-free rate and discount at the risk-free rate

This is known as using risk-neutral valuation

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

12

Return

When we are valuing an option in terms of

the underlying stock the expected return

on the stock is irrelevant

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

13

p

(1

p)

Su = 22

u = 1

Sd = 18

d = 0

e rT d e 0.120.25 0.9

p

0.6523

ud

1.1 0.9

20e0.12

0.25 = 22p + 18(1 p ); p = 0.6523

Alternatively, we can use the formula

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

14

S

3

2

5

6

0.

0.34

77

Su = 22

u = 1

Sd = 18

d = 0

e0.120.25 [0.65231 + 0.34770]

= 0.633

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

15

A Two-Step Example

Figure 12.3, page 280

24.2

22

19.8

20

18

16.2

Each

K=21, r =12%

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

16

Figure 12.4, page 280

D

22

20

1.2823

2.0257

18

0.0

19.8

0.0

C

F

24.2

3.2

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

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

17

Figure 12.7, page 283

50

4.1923

60

1.4147

40

9.4636

72

0

48

4

32

20

r = 5%, u =1.32, d = 0.8, p = 0.6282

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

18

Option is American (Figure 12.8, page 284)

72

0

60

50

5.0894

The American feature

increases the value at node

C from 9.4636 to 12.0000.

48

4

1.4147

40

12.0

C

32

20

the option from 4.1923 to

5.0894.

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

19

Delta

Delta

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

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

20

Choosing u and d

One way of matching the volatility is to set

u e

d 1 u e

of the time step. This is the approach used

by Cox, Ross, and Rubinstein (1979)

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

21

Paying Stocks

For

and futures the basic procedure for

constructing the tree is the same except

for the calculation of p

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

22

p

ad

ud

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

yield on the index

( r r ) t

ae f

for a currency where r f is the foreign

risk - free rate

a 1 for a futures contract

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

23

In

necessary to give good option values

DerivaGem allows up to 500 time steps to

be used

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

24

The

at what happens to the price of a

European call option as the time step

tends to zero

See Appendix to Chapter 12

Fundamentals of Futures and Options Markets, 8th Ed, Ch 12, Copyright John C. Hull

2013

25

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