Lecture Note Eight:

Binomial Option Pricing

FINA2322 Derivatives
Faculty of Business and Economics
University of Hong Kong

Dr. Huiyan Qiu

8-1
 Outline
How the binomial model works and how to use it
• One-period and multiple period binomial tree
• Call options and put options
• European options and American options
• Options on other assets: currencies

Appendix: Pricing options using real probability

Reading: Chapter 10, 11

8-2
Introduction to Binomial Option Pricing
Binomial option pricing enables us to determine the
price of an option, given the characteristics of the stock
or other underlying asset
• To perform synthetic replication
• A simple yet powerful approach
Assumption: the price of the underlying asset follows a
binomial distribution — that is, the asset price in each
period can move only up or down by a specified amount.

8-3
 A One-Period Binomial Tree
Consider a European call option on the stock of XYZ, with a
$40 strike and 1 year to expiration
• XYZ does not pay dividends, and its current price is $41
• The continuously compounded risk-free interest rate is 8%
The following figure depicts possible stock prices over 1 year,
i.e., a binomial tree
S = 41
$60 K = 40
r = 8%
$41 δ=0
T=1
$30
8-4
 Option Payoff
Stock Price in 1 Year
$30 $60
Option Payoff $0 $20

$60 $20

$41 C

$30 $0
8-5
 Computing the Option Price
Let’s look at the payoff on the following portfolio:
• Buy 2/3 shares of XYZ
• Borrow $18.462 at the risk-free rate (8%)
Then the portfolio payoff is

Stock Price in 1 Year

$30 $60
2/3 purchased shares $20 $40
Repay the loan of $18.462 – $20 – $20
Portfolio Payoff 0 $20
8-6
Computing the Option Price (cont’d)
The payoff on the portfolio is the same as the payoff on
the option.
What is the price of the 40-strike call option?
• The current price (or cost) of the portfolio is
2/3 × 41 – 18.462 = $8.871
If the option price is higher  sell the option, buy 2/3 of
a share of XYZ, borrow $18.462  positive time-0 cash
flow, zero final payoff
If the option price is lower  also arbitrage
8-7
Computing the Option Price (cont’d)
No arbitrage  the price of 40-strike call option must be
$8.871, the cost of the replicating portfolio.

The payoff to a call is replicated (duplicated) by

borrowing to buy shares. The replicating portfolio forms
a synthetic call option

The value 2/3 is the delta () of the option: the number
of shares that replicates the option payoff

8-8
 The Binomial Solution
To determine the price of an option, we perform synthetic
replication, that is, we find a replicating portfolio that
imitates the option no matter the stock rises or falls.
By Law of No Arbitrage, the value of the replication
portfolio is equal to the price of the option.

8-9
 The Binomial Solution: Setting
Suppose that the stock has a continuous dividend yield of 
and the risk-free interest rate is r.
The length of one period is h and stock price in each period
goes up or down by a specified amount.
Let uS0 /dS0 denote the stock price when the price goes up /
down.
uS0 Cu

S0 C0
dS0 Cd
What is C0, the value of the option? 8-10
 The Binomial Solution (cont’d)
Use the stock and borrowing / lending (or the risk-free
bond) to create the replicating portfolio. The portfolio
consists of
•  shares of stock (investing in  shares)
• a dollar amount B in lending (investing amount B in risk-
free bond)
The value of the replicating portfolio one period later, at
time h, with stock price Sh, is

𝛿h 𝑟h
 
Δ𝑒 × 𝑆h +𝐵 ×𝑒 8-11
 The Binomial Solution (cont’d)
 At the prices Sh = uS and Sh = dS, a replicating portfolio
will satisfy
(  eh  uS) + (B  erh) = Cu
(  eh  dS) + (B  erh) = Cd
Solving for  and B gives

8-12
 The Binomial Solution (cont’d)
 The cost of creating the replicating portfolio is the
cash flow required to buy the shares and invest in
bonds.

Thus, the price of the option is

8-13
 Arbitraging a Mispriced Option
If the observed option price differs from its theoretical
price, arbitrage is possible
• If an option is overpriced, we can sell the option.
• However, the risk is that the option will be in the money
at expiration, and we will be required to deliver the stock.
To hedge this risk, we long the replicating portfolio at the
same time.
If an option is underpriced, we buy the option and sell
the replicating portfolio at the same time.

8-14
 Constructing a Binomial Tree
 Goal: to characterize future uncertainty about the stock
price in an economically reasonable way.
In the absence of uncertainty, a stock must appreciate at
the risk-free rate less the dividend yield. Thus, from time t
to time t+h, we have

The price next period equals the forward price

8-15
Constructing a Binomial Tree (cont’d)
With
  uncertainty, the stock price evolution CAN be modeled
as

Where  is the annualized standard deviation of the continuousl

compounded return

We can also rewrite (8.4) as

We refer to a tree constructed using equation (8.5) as a

“forward tree.”
8-16
 Summary
In order to price an option, we need to know
• Stock price S
• Strike price K
• Standard deviation of returns on the stock σ
• Dividend yield δ
• Risk-free rate r
• Time to expiration T
We can approximate the future distribution of the stock by
creating a binomial tree using equation (8.5) (forward tree)
Once we have the binomial tree, it is possible to price the
option using equation (8.3)
8-17
 Another One-Period Example
Reconsider
  the European call option on the stock of XYZ
with K = $40 and h = 1 year.
XYZ does not pay dividends (δ = 0), and its current price S0
= $41. The continuously compounded risk-free interest rate
r = 8%.
Instead of assuming the price next year will be either $60 or
$30, here, we assume that the volatility  = 30%.
By construction,

8-18
Another One-Period Example (cont’d)
 Accordingly, uS = $59.954, dS = $32.903 and Cu =
$19.954, Cd = $0. Using formula (8.3), the option price
is

∆ = 0.738, B = –$22.405 (not showing here)

8-19
Another One-Period Example (cont’d)
The binomial tree:
$59.954
$19.954

$41
$7.839
∆=0.738
B=–$22.405

$32.903
$0.000
8-20
 Risk-Neutral Pricing
 We can interpret the terms (e(r–)h – d )/(u – d) and
(u – e(r–)h )/(u – d) in the binomial solution (8.3) as
probabilities (adding to 1).
Let

Then the binomial solution (8.3) can then be written as

8-21
 Risk-Neutral Probability
 p* is the value that p would have in equilibrium if
investors were risk neutral. Risk neutral investors
demand for risk-free rate of return.

which leads to

p* is the risk-neutral probability NOT the true

probability that the stock price will go up.

8-22
 Understanding Risk-Neutral Pricing
In the binomial option pricing formula:

C  e [ p*Cu  (1  p* )Cd ]
-rh

we use the risk-neutral probability p* to substitute the

statistical probability p in pricing derivative securities. It
is thus often called risk-neutral pricing approach.
The option pricing formula can be said to price options
as if investors are risk-neutral.

8-23
 Understanding Risk-Neutral Pricing
Risk-neutral pricing is an interpretation of the
formula. The formula in turn arises from finding the
cost of the portfolio that replicates the option itself
Risk-neutral pricing can be used where other pricing
methods are too difficult
Risk-neutral pricing is the basis for Monte Carlo
valuation, in which asset prices are simulated under the
assumption that assets earn the risk-free rate, and these
simulated prices are used to value the option

8-24
An Expression of p* in Forward Tree
Given
  u and d by (8.5), we have in forward tree

p* is decreasing in h and approaches 0.5 as h approaches 0.

8-25
 Question
If we are given the expected return on stock (or the real
probability of stock price going up), we should be able
to use standard discounted cash flow (DCF) analysis to
find option value. Will we get consistent number?
• The answer is YES. However, discounted cash flow is not
used in practice to price options. See Appendix for
discussion on pricing options with true probabilities. (For
your reference only.)

8-26
 Alternative Binomial Trees
 
There are other ways besides forward tree to construct
a binomial tree that approximates a lognormal
distribution
The lognormal tree (The Jarrow-Rudd tree)

The Cox-Ross-Rubinstein binomial tree

8-27
 Alternative Binomial Trees (cont’d)
 An acceptable tree must match the standard deviation of the
continuously compounded return on the asset and must generate
an appropriate distribution as h  0
Different methods of constructing the binomial tree will result in
different u and d stock movements, all have the same ratio of u
to d:

• That is, however the tree is constructed, the proportional distance

between u and d measures volatility

8-28
 Alternative Binomial Trees (cont’d)
No
  matter how we construct the tree, to determine the risk-
neutral probability, we use

and to determine the option value, we use

Although the three different binomial models give different

option prices for finite n, as n   all three binomial trees
approach the same price. (The price determined by B-S
model.)
8-29
 A Two-Period European Call
We can extend the previous example to price a 2-year option,
assuming all inputs are the same as before: S = $41.00, K =
$40.00, σ =0.30, r = 0.08, T = 2.00 years, δ = 0.00, and h
= 1.000.
Steps:
• calculate the u and d, find stock price at each node, and
construct the binomial true.
• Work backward through the tree. Find option value at
each node.

• u = e0.08+0.3 = 1.4623; d = e0.08-0.3 = 0.8025

8-30
 A Two-Period European Call (cont’d)
The binomial tree:

Numbers in bold italic

signify that exercise is
optimal at that node. 8-31
 A Two-period European Call (cont’d)
 Note that an up move by the stock followed by a down move
(Sud) generates the same stock price as a down move followed
by an up move (Sdu). This is called a recombining tree.
(Otherwise, we would have a nonrecombining tree)

8-32
 Pricing the Call Option
To price an option with two binomial periods, we work
backward through the tree
In year 2, since we are at expiration, the option value is
max (0, S – K)

Stock Price $87.669 $48.114 $26.405

Option Value $47.669 $8.114 $0.000

8-33
 Pricing the Call Option (cont’d)
 u = e0.08+0.3 = 1.4623; d = e0.08-0.3 = 0.8025

We compute the option value using equation (8.3),

8-34
 Pricing the Call Option (cont’d)
 In year 1, if stock price is 59.954, the payoff to option
next year is Cu = 47.669 or Cd = 8.114. Option value is

If stock price is 32.903, the payoff to option next year

is Cu = 8.114 or Cd = 0. Option value is

8-35
 Pricing the Call Option (cont’d)
 In year 1,

Stock Price $59.954 $32.903

Option Value $23.029 $3.187

In year 0, stock price is 41. The payoff to option next

year is Cu = 23.029 or Cd = 3.187. Option value is

8-36
 Pricing the Call Option (cont’d)
Notice that
The option was priced by working backward through the
binomial tree
The option price is greater for the 2-year than for the 1-year
option ($7.839)
The option’s  and B are different at different nodes. At a
given point in time,  increases to 1 as we go further into the
money
Permitting early exercise would make no difference. At every
node prior to expiration, the option price is greater than S – K;
thus, we would not exercise even if the option was American
8-37
 Risk-Neutral Pricing Approach
Binomial option pricing formula:
−𝑟h ∗ ∗
𝐶=𝑒 [ 𝑝 𝐶 𝑢 +(1 − 𝑝 ) 𝐶 𝑑 ]( 8.3)
 

For two-period model,

  −𝑟h ∗ ∗
𝐶𝑢 =𝑒 [ 𝑝 𝐶 𝑢𝑢+(1− 𝑝 )𝐶𝑢𝑑 ]
Therefore,
  −𝑟h ∗ ∗
𝐶=𝑒 [ 𝑝 𝐶 𝑢 +(1− 𝑝 )𝐶 𝑑 ]
8-38
 Risk-Neutral Pricing Approach
For two-period model,

−𝑟h ∗ ∗
 

𝐶=𝑒 [𝑝 𝐶 𝑢+(1−𝑝 )𝐶 𝑑]
The option value is the risk-neutral expected payoff
discounted at the risk-free rate.

8-39
 Risk-Neutral Pricing Approach
 Two-period European Call: S = $41.00, K = $40.00, σ
=0.30, r = 0.08, T = 2.00 years, δ = 0.00, and h = 1.000. p* =
0.4256 as calculated before.
Cuu=$47.669, Cud=Cdu=$8.114, Cdd=0.

Previously calculated option price is $10.737 (Difference

caused by rounding error).

8-40
 Many Binomial Periods
Dividing the time to expiration into more periods allows us to
generate a more realistic tree with a larger number of
different values at expiration
• Consider the previous example of the 1-year European
call option
• Let there be three binomial periods. Since it is a 1-year
call, this means that the length of a period is h = 1/3.
(T=1)
• Assume that other inputs are the same as before (so, S =
$41.00, K = $40.00, σ =0.30, r = 0.08, T = 1.00 year, δ =
0.00, and h = 1/3.)
8-41
 Many Binomial Periods (cont’d)
The stock price and
option price tree for
this option

8-42
 Many Binomial Periods (cont’d)
Note that since the length of the binomial period is shorter, u
and d are smaller than before: u = 1.2212 and d = 0.8637 (as
opposed to 1.462 and 0.803 for h = 1)
• The second-period nodes are computed as follows
Su  $41e0.081 / 30.3 1/ 3
 $50.071
Sd  $41e0.081 / 30.3 1/ 3
 $35.411
• The remaining nodes are computed similarly
Analogous to the procedure for pricing the 2-year option, the
price of the three-period option is computed by working
backward using equation (8.3). The option price is $7.074.
8-43
 The Binomial Tree
The binomial model
implicitly assigns
probabilities to the
various nodes.

8-44
 Using Risk-Neutral Probability
Risk-neutral probability of stock price going up:
(𝑟 − δ)h
∗  𝑒 −𝑑 1 1
𝑝 = = 𝜎 √ h = 0.3 √1 /3 =0.4568
𝑢− 𝑑 𝑒 +1 𝑒 +1

The value of option is max(ST – K, 0):

Node uuu uud udd ddd

Prob. p*3 3p*2(1-p*) 3p*(1-p*)2 (1-p*)3
Value 34.678 12.814 0 0

8-45
 Risk-Neutral Pricing
Using risk-neutral pricing approach,
 
−𝑟𝑇
𝐶 =𝑒 ¿
In general, if n is the number of binomial steps,
  𝑛
𝑛 ∗𝑖
𝐶=𝑒
−𝑟𝑇
∑( 𝑖 )
𝑝 ¿¿
𝑖=0 8-46
 Connection to B-S Model
Holding fixed the time to expiration, we vary the number, n,
of the binomial steps to get binomial call prices. (T = 1)

n 1 3 4 10 50 100 500 ∞
C 7.839 7.074 7.160 7.065 6.969 6.966 6.960 6.961
As n goes to infinite, we have the limiting value for the price.
This price is given by the Black-Scholes formula. Thus, the
B-S model is a limiting case of the binomial formula for the
price of a European option.

8-47
 Put Options
We compute put option prices using the same stock price
tree and in the same way as call option prices
The only difference with a European put option occurs
at expiration
• Instead of computing the price as max (0, S –
K), we use max (0, K – S)

8-48
 Put Options (cont’d)
A binomial tree for a
European put option
with 1-year to
expiration

S = $41.00, K = $40.00, σ = 0.30,

r = 0.08, T = 1.00 year, δ = 0.00,
and h = 0.333.
8-49
 Risk-Neutral Pricing
Risk-neutral probability is p* = 0.4568 as calculated
before.

Using risk-neutral pricing approach,

− 𝑟𝑇
 

𝑃=𝑒 ¿ 8-50
 American Options
The value of the option if it is left “alive” (i.e., unexercised)
is given by the value of holding it for another period,
equation (8.3)
The value of the option if it is exercised is given by max (0, S
– K) if it is a call and max (0, K – S) if it is
a put
For an American call, the value of the option at a node is
given by

C ( S , K , t )  max( S  K , e  rh [C (uS , K , t  h ) p * 
C ( dS , K , t  h )(1  p*)])
8-51
 American Options (cont’d)
The valuation of American options proceeds as follows
• At each node, we check for early exercise
• If the exercise value is greater than holding value, we
assign the exercise value to the node. Otherwise, we
assign the holding value (the value of the option
unexercised)
• We work backward through the tree as usual

8-52
 American Options (cont’d)
Consider an American version of
the put option valued in the
previous example

S = $41.00, K = $40.00, σ =0.30,

r = 0.08, T = 1.00 year, δ = 0.00,
and h = 0.333. 8-53
$8.363 if holding
 American Options (cont’d)
The only difference in the binomial tree occurs at the Sdd
node, where the stock price is $30.585.
• The American option at that point is worth $40 – $30.585
= $9.415, its early-exercise value (as opposed to $8.363 if
unexercised).
• The greater value of the option at that node ripples back
through the tree
Thus, an American option is at least as valuable as the
otherwise equivalent European option
8-54
 Options on Other Assets
Pricing options with different underlying assets requires
adjusting the risk-neutral probability for the borrowing cost
or lease rate of the underlying asset
Thus, we can use the formula for pricing an option on stock
with an appropriate substitution for the dividend yield

8-55
 Options on Currency
For a currency with spot price x0, the forward price is

  (𝑟−𝑟 𝑓 )𝑡
𝐹 0,𝑡 =𝑥 0 𝑒
where rf is the foreign interest rate.

Thus, we construct the binomial tree using

  (𝑟−𝑟 𝑓 )h+σ √ h
𝑢𝑥=𝑥 𝑒
  (𝑟 −𝑟 𝑓 )h −σ √ h
𝑑𝑥=𝑥 𝑒
8-56
 Options on Currency (cont’d)
Investing in a “currency” means investing in a money-
market fund or fixed income obligation denominated in
that currency
Replicating Portfolio:
Lend B amount of domestic currency
Invest Δ amount of foreign currency
At time h, the value of portfolio:
e rh inBdomestic currency
+ r f h in foreign currency
e 
8-57
 Options on Currency (cont’d)
 The exchange rate at time h is either ux or dx
Therefore, the two equations equating the portfolio value
and option value at h are
 
𝑟𝑓 h 𝑟h
Δ×𝑢𝑥𝑒 +𝑒 ×𝐵=𝐶𝑢
The risk-neutral probability of an up move is

8-58
 Options on Currency (cont’d)
Consider a dollar-denominated American put option on
the euro, where
• The current exchange rate is $1.05/€
• The strike is $1.10/€
• The euro-denominated interest rate is 3.1%
• The dollar-denominated rate is 5.5%
• The volatility is 10%
The option expires in 6 months and there are 3 periods.
(T = 0.50 and h = 0.167)
8-59
 Options on Currency (cont’d)
The binomial tree for
the American put
option on the euro

Because volatility is low and

the option is in-the-money,
early exercise is optimal at
three nodes prior to expiration. 8-60
End of the Notes!

8-61
 Appendix

Pricing Options
with True Probabilities

8-62
 The Objective
To prove algebraically that computing the option price in a
consistent way using , the continuously compounded
expected return on the stock, gives the same option price
as performing the risk-neutral calculation.
Suppose the stock does not pay dividend.
If p is the true probability of the stock going up, p must be
consistent with u, d, and 

puS  1  p  dS  e S h

8-63
 Expected Payoff
Solving for p

e h  d
p
ud
Using p, the actual expected payoff to the option one
period later is

eh  d u  eh
pCu  1  p  Cd  Cu  Cd
ud ud

8-64
 The Appropriate Discount Rate
An option is equivalent to holding a portfolio consisting
of ∆ shares of stock and B bonds.
The required return on any portfolio is the weighted
average of the returns on the assets in the portfolio
Let  denote the appropriate per-period discount rate for
the option. Then the expected return on the portfolio (or
option) is

h S h B
e  e  e rh
S  B S  B
8-65
Pricing Options with True Probabilities
Option price is thus

h  e h
 d u  eh

C e  Cu  Cd  (A.1)
 ud ud 
We want to show that it is the same as

e  rh
 Cu p*  Cd ( 1  p*)
e d
rh
where p* 
ud
8-66
 Pricing Options with True Probabilities

S  B (eh  d )Cu  (u  eh )Cd

(A.1)  h 
e S  e Brh
ud

Cu  C d e -rh (uC d  dCu )

Note that Δ  and B 
uS  dS ud
Cu  Cd  e -rh (uCd  dCu ) e -rh [e rh Cu  e rh Cd  uCd  dCu ]
Thus, S  B  
ud ud
e -rh [( e rh  d )Cu  (u  e rh )Cd ]

ud
h h h
e ( C  C )  ( uC  dC ) ( e  d )C  ( u  e )Cd
Seh  Berh  u d d u
 u
ud ud
8-67
 Pricing Options with True Probabilities

Therefore,

e  rh [(e rh  d )Cu  (u  e rh )Cd ] (eh  d )Cu  (u  eh )Cd

(A.1)  h h

(e  d )Cu  (u  e )Cd ud
(e rh  d )Cu  (u  e rh )Cd
 e  rh
ud

It is the same as the option price calculated by risk-

neutral probabilities.

8-68
 Pricing Options with True Probabilities

Note that it does not matter whether we have the

“correct” value of  to start with
Any consistent pair of  and  will give the same option
price
Risk-neutral pricing is valuable because setting
 = r results in the simplest pricing procedure.

8-69
 A One-period Example
S = $41.00 K = $40.00
 = 0.30 r = 0.08
T = 1.00 year  = 0.00
h = 1.000
$59.954
$41.000 Cu = $19.954
C = $7.839
 = 0.738
B = - $22.405 $32.903
Cd = $0.000
8-70
 A One-period Example
Suppose   the risk-adjusted continuously compounded
expected return on the underlying = 15%
59.954
u  1.4623
41.000
32.903
d  0.8025
41.000
What is the true probability of the stock going up?
What is the expected payoff to the option in one period?

8-71
 A One-period Example
True probability p of stock price going up:

e0 .15  0.8025
p  0.5446
1.4625  0.8025
Expected option payoff:

0.5446  $19.954  (1  0.5446)  $0  $10.867

The appropriate discount rate to be used?

8-72
 A One-period Example
 = 0.738 B = - $22.405 (Neither depends on p or .)
Knowing ∆ and B is equivalent to knowing the option value
(the denominator)
0 .738  $ 41  e 0 .15
 $ 22 .405  e 0 .08
e γh  
0.738  $ 41  ( $ 22.405) 0.738  $ 41  ( $ 22.405)
 3.85305  e0 .15  ( 2.85305)  e0 .08  1.386

γ  ln 1.386   32.64%

Option value:
 
$10.867 e 0.3264  $7.839
8-73