298 CHAPTER 13 Bi APPENDIX DERIVATION OF THE BLACK-SCHOLES-MERTON OPTION-PRICING FORMULA FROM A BINOMIAL TREE (One way of deriving the famous Black-Scholes-Merton result for valuing a European option on a non-dividend-paying stock is by allowing the number of time steps in a binomial tree to approach infinity. . ‘Suppose that a tree with m time steps is used to value a European call option with strike price K and life 7. Each step is of length T/n. If there have been j upward movements and n—j downward movements on the tree, the final stock price is ‘Squld"-i, where u is the proportional up movement, d is the proportional down movement, and Sp is the initial stock price. The payoff from a European call option is then max(Syu/d"/ — K, 0) From the properties of the binomial distribution, the probability of exactly j upward and n— j downward movements is given by nl yd a= mart It follows that the expected payoff from the call option is ap — manda — K, 0) As the tree represents movements in a risk-neutral world, we can discount this at the risk-free rate r to obtain the option price: ~K,0) (3.1) GP ao mans The terms in equation (13A.1) are nonzero when the final stock price is greater than the strike price, that is, when sulati > K 1n(55/K) > —jln(u) —(n — spina) and d= e*V7, this condition becomes In(So/K) > noyT]n ~ 2jo/Tjn Since u or 8 !a(50/K) . I? 2a JT In s Equation (13A.1) can therefore be written ge rule) a MA13 ud he a he Binomial Trees 299 where 1 _In(So/K) 2” 2oJTTn For convenience, we define ¥ ta — py tulad! (134.2) a= Damrey (134.2) and . a= Lae (134.3) so that : © (SU, — KU2) asad) Consider first U;. As is well known, the binomial distribution approaches a normal distribution as the numbef of trials approaches infinity. Specifically, when there are trials and p is the probability of success, the probability distribution of the number of successes is approximately normal with mean mp and standard deviation y/np(I = p). ‘The variable U; in equation (13A.3) is the probability of the number of successes being more than a. From the properties of the normal distribution, it follows that, for large n, where NV is the cumulative probability distribution function for a standard normal variable, Substituting for a, we obtain In(So/K)__, VRP 3) u,=n(— BOD _, AOD ss ° Gahanna wa) BAO From equations (13.15) to (13.18), we have gm in Po Ein win By expanding the exponential functions in a series, we see that, as n tends to infint (l= p) tends to} and vn(p — }) tends to 0 /2)vT 2a so that in the limit, as n tends to infinity, equation (13A.6) becomes eit) In(So/ K+ at u=n( te _ a3a7300 CHAPTER 13 We now move on to evaluate Uj. From equation (13A.2), we have uta — par! 3a) Define : . a wi te 349) Tt then follows that, Lope ee peda and we can write equation (13.8) as n Uy = [ow = pdt ety - py [pu + (1 - py Toe wae ‘Ya - py ‘Since the expected rate of return in the’risk-neutral world is the risk-free rate r, it follows that pu-+ (I~ pid =e! and aera ee This shows that U; involves a binomial distribution where the probability of an up movement is p* rather than p. Approximating the binomial distribution with a normal distribution, we obtain, similarly to equation (134.5), on( ts and substituting for a gives, as with equation (134.6), uy, netn(_—In/)_5, Wate") ae "ao wD) Substituting for w and d in equation (13A.9) gives By expanding the exponential functions in a series we see ‘that, as n tends to infinity, p'(1— p’) tends to } and Yap" — $) tends to ($07/2)VT Pa with the result that In(S/K) + (r-+ 07/2) iF (43A.10)[Binomial Trees From equations (13.4), (13A.7), and (13A.10), we have 8) ¢ = SN(@) ~ Ke" Na) where _ In(So/K) + (r+ 2/207 = oT %) ‘This is the Black~Scholes-Merton formula for the valuation of a European call option. It will be discussed in Chapter 15. An alternative derivation is given in the appendix to that chapter. it