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Chapter 11
18
S0u
ƒu
S0
ƒ S0d
ƒd
Options, Futures, and Other Derivatives
7th Edition, Copyright © John C. Hull
2008 7
Generalization
(continued)
Consider the portfolio that is long shares and
short 1 derivative
S0u– ƒu
S0d– ƒd
The portfolio is riskless when S0u– ƒu = S0d– ƒd
or
ƒu f d
S 0u S 0 d
Options, Futures, and Other Derivatives
7th Edition, Copyright © John C. Hull
2008 8
Generalization
(continued)
where
e drT
p
ud
Options, Futures, and Other Derivatives
7th Edition, Copyright © John C. Hull
2008 10
p as a Probability
It is natural to interpret p and 1-p as probabilities
of up and down movements
The value of a derivative is then its expected
payoff in a risk-neutral world discounted at the
risk-free rate
S0u
p ƒu
S0
ƒ S0d
(1–
p) ƒd
Options, Futures, and Other Derivatives
7th Edition, Copyright © John C. Hull
2008 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 risk-free
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
24.2
22
20 19.8
18
16.2
Each time step is 3 months
K=21, r=12%
72
D
0
60
B
50 1.4147 48
A E
5.0894 4
40
C
12.0 32
F 20
u e t
d 1 u e t
ad
p
ud