Binomial Option Pricing

• A one-period binomial tree

• Two or more binomial periods
• Put options
• American options
• Options on other assets

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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
• The binomial option pricing model assumes that 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
• The binomial model is often referred to as the
Cox-Ross-Rubinstein pricing model

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 A One-Period Binomial Tree
Example
• 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

$60


$41
@
@
@
@R$30
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 Computing the Option Price

• Next, consider two portfolios

• Portfolio A: buy one call option
• Portfolio B: buy 2/3 shares of XYZ and borrow
$18.462 at the risk-free rate
• Costs
• Portfolio A: the call premium, which is unknown
• Portfolio B: 2/3 × $41 − $18.462 = $8.871

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 Computing the Option Price (cont’d)

Payoffs:
Portfolio A: Stock Price in 1 Year
$30 $60
Payoff 0 $20

Portfolio B: Stock Price in 1 Year

$30 $60
2/3 purchased shares $20 $40
Repay loan of $18.462 -$20 -$20
Total payoff 0 $20

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 Computing the Option Price (cont’d)
• Portfolios A and B have the same payoff. Let’s appeal to
the law of one price
• sold in two different markets;
• no restrictions exist on the sale;
• transportation costs of moving the product between
markets are equal
then the products price should be the same in both
markets. Therefore
• Portfolios A and B should have the same cost. Since
Portfolio B costs $8.871, the price of one option must
be $8.871
• There is a way to create the payoff to a call by buying
shares and borrowing. Portfolio B is a synthetic call
• One option has the risk of 2/3 shares. The value 2/3
is the delta (∆) of the option: The number of shares
that replicates the option payoff
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 The Binomial Solution

• How do we find a replicating portfolio consisting of shares

of stock and a dollar amount B in lending, such that the
portfolio imitates the option whether the stock rises or
falls?
• If the length of a period is h, the interest factor per
period is erh
• uS denotes the stock price when the price goes up,
and dS denotes the stock price when the price goes
down

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 The Binomial Solution (cont’d)
Stock price tree: Corresponding tree for
the value of the option:
uS Cu
 

S@ C@
@ @
@ @
@RdS @RCd
• Note that u(d) in the stock price tree is interpreted as one
plus the rate of capital gain (loss) on the stock if it goes
up (down)
The value of the replicating portfolio at time h, with stock
price Sh , is
∆Sh + erh B
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 The Binomial Solution (cont’d)

• At the prices Sh = uS and Sh = dS, a replicating

portfolio will satisfy

(∆ × uS) + (B × erh ) = Cu

(∆ × dS) + (B × erh ) = Cd
• Solving for ∆ and B gives
Cu − Cd
∆= (1)
S(u − d)
uCd − dCu
B = e−rh (2)
u−d

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 The Binomial Solution (cont’d)

• The cost of creating the option is the cash flow required

to buy the shares and bonds. Thus, the cost of the option
is ∆S + B
erh − d u − erh

∆S + B = e−rh Cu + Cd (3)
u−d u−d
• The no-arbitrage condition is

u > erh > d (4)

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Can you verify the example solutions?

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 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 can buy a synthetic
option at the same time we sell the actual option
• If an option is underpriced, we buy the option. To
hedge the risk associated with the possibility of the
stock price falling at expiration, we sell a synthetic
option at the same time

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A Graphical Interpretation of the Binomial
Formula

• The portfolio describes a line with the formula

Ch = ∆ × Sh + erh B

Where Ch and Sh are the option and stock value after


one binomial period
• We can control the slope of a payoff diagram by varying
the number of shares, ∆ , and its height by varying the
number of bonds, B
• Any line replicating a call will have a positive slope (
∆ > 0) and negative intercept (B < 0). (For a put,
∆ < 0 and B > 0)

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 A Graphical Interpretation of the Binomial
Formula (cont’d)
The payoff to an Option
expiring call option is Payoff
the red heavy line. The
payoff to the option at
the points dS and uS
are Cd and Cu (at
point E and D). The
portfolio consisting of
∆ shares and B bonds
Cu = uS − K Db
has intercept erh B
and slope ∆, and by slope=∆ Rise=Cu − Cd
construction goes Cd = 0 Eb Sh (Stock
through both points E dS K uS price after
and D. The slope of Intercept b one period)
= erh B
the blue line is Run=uS − dS
calculated as Rise/Run
between points E and
D, which gives the
formula for ∆.
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 Pricing with Dividends

• Suppose that the stock has a continuous dividend yield of

δ, which is reinvested in the stock. Thus, if you buy one
share at time t, at time t + h you will have eδh shares
• Using same procedure, we obtain

e(r−δ)h − d u − e(r−δ)h

∆S + B = e−rh Cu + Cd (5)
u−d u−d
• We can treat the previous case as δ = 0

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 Risk-Neutral Pricing
• We can interpret the terms (e(r−δ)h − d)/(u − d) and
(u − e(r−δ)h )/(u − d) as probabilities
• Let
e(r−δ)h − d
p∗ = (6)
u−d
• Then equation (3) can then be written as

C = e−rh [p∗ Cu + (1 − p∗ )Cd ] (7)

If we use p∗ to compute the expected undiscounted stock

price

p∗ uS + (1 − p∗ )dS = e(r−δ)h S = Ft,t+h (8)

 Where p∗ is the risk-neutral probability of an

increase in the stock price
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 Constructing a Binomial Tree

• 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

Ft,t+h = St+h = St e(r−δ)h (9)

• The price next period equals the forward price

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 Constructing a Binomial Tree (cont’d)
• With uncertainty, the stock price evolution is
√
uSt = Ft,t+h e+σ h
√ (10)
h
dSt = Ft,t+h e−σ

Where σ is the annualized standard deviation

 √ of the
continuously compounded return, and σ h is standard
deviation over
p a period of length h. For example, monthly
volatility is 1/12 times the annual volatility
• We can also rewrite as
√
u = e(r−δ)h+σ h
√
d = e(r−δ)h−σ h

 We refer to a tree constructed using equation as a

“forward tree.”
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 Practice
Assume the following data on a 6-month call option.
K = $50, S = $48, r = 4.0%, σ = 0.27. (For simplicity, let’s
assume these are for 6 months, not annualized interest rate or
standard deviation, for this computation only.) What is the
risk neutral probability of an up move in the stock price?

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 Practice

What is the highest expected stock price after 6 months

according to the binomial model?

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 A One-Period Binomial Tree
Another Example
• 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 annual standard deviation is 30%.
• The following figure depicts possible stock prices over 1
year, i.e., a binomial tree

$59.954


$41
@
@
@
@R$32.903
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 Computing the Option Price

• Next, consider two portfolios

• Portfolio A: buy one call option
• Portfolio B: buy 0.7376 shares of XYZ and borrow
$22.405 at the risk-free rate
• Costs
• Portfolio A: the call premium, which is unknown
• Portfolio B: 0.7376 × $41 − $22.405 = $7.839

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 Computing the Option Price (cont’d)

Payoffs:
Portfolio A: Stock Price in 1 Year
$32.903 $59.954
Payoff 0 $19.954

Portfolio B: Stock Price in 1 Year

$32.903 $59.954
0.7376 purchased shares $24.271 $44.225
Repay loan of $22.405 -$24.271 -$24.271
Total payoff 0 $19.954

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 Computing the Option Price (cont’d)

• Portfolios A and B have the same payoff. Therefore

• Portfolios A and B should have the same cost. Since
Portfolio B costs $7.839, the price of one option must
be $7.839
• There is a way to create the payoff to a call by buying
shares and borrowing. Portfolio B is a synthetic call
• One option has the risk of 0.7376 shares. The value
0.7376 is the delta (∆) of the option: The number of
shares that replicates the option payoff

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 Summary

• In order to price an option, we need to know

• Stock price
• Strike price
• Standard deviation of returns on the stock
• Dividend yield
• Risk-free rate
• Using the risk-free rate and σ, we can approximate the
future distribution of the stock by creating a binomial tree
using equation
• Once we have the binomial tree, it is possible to price the
option using equation

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 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
Binomial tree for $87.669(Suu)
pricing a European $47.669

call option; assumes

S = $41.00, K = $59.954(Su)
$23.029
$40.00, σ = 0.30, r = ∆=1.000
B=–$36.925
0.08, T = 2.00 years, $41.000(S)
δ = 0.00, and $10.737
∆=0.734 $48.114(Sud = Sdu )
h = 1.000. At each B=–$19.337 $8.114
node the stock price,
$32.903(Sd)
option price, ∆, and $3.187
B are given. Option ∆=0.374
B=–$9.111
prices in bold italic
signify that exercise is
$26.405
optimal at that node. $0.000

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 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)

Sud = Sdu = u×d×$41 = e0.08+0.3 ×e0.08−0.3 ×$41 = $48.114

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 Pricing the Call Option

• To price an option with two binomial periods, we work

backward through the tree
• Year 2, Stock Price=$87.669: since we are at
expiration, the option value is max
(0, S − K) = $47.669
• Year 2, Stock Price=$48.114: similarly, the option
value is $8.114
• Year 2, Stock Price=$26.405: since the option is out
of the money, the value is 0

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 Pricing the Call Option (cont’d)

• Year 1, Stock Price=$59.954: at this node, we compute

the option value using equation (3), where uS is $87.669
and dS is $48.114
• Year 1, Stock Price=$32.903: again using equation (3),
the option value is $3.187
• Year 0, Stock Price = $41: similarly, the option value is
computed to be $10.737

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Let’s verify

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 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
• The option ∆ 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

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 Practice
Draw the binomial tree listing only the option prices at each
node. Assume the following data on a 6-month call option,
using 3-month intervals as the time period.
K = $40, S = $37.90, r = 5.0%, σ = 0.35. (These are annual
rates.)

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 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
• Assume that other inputs are the same as before (so,
r = 0.08 and σ = 0.3)

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 Many Binomial Periods (cont’d)
• The stock price and option price tree for this option $74.678
$34.678

Binomial tree for

$61.149
pricing a European $22.202
∆=1.000
call option; assumes B=–$38.947

S = $41.00, K = $50.071
$40.00, σ = 0.30, r = $12.889
∆=0.922
$52.814
$12.814
B=–$33.264
0.08, T = 1.00 year, $41.000 $43.246
$7.074 $5.700
δ = 0.00, and ∆=0.706 ∆=0.829
B=–$21.885 B=–$30.139
h = 0.333. At each
node the stock price, $35.411
$2.535
option price, ∆, and ∆=0.450 $37.351
B=–$13.405 $0.000
B are given. Option
prices in bold italic $30.585
$0.000
signify that exercise is ∆=0.000
B=$0.000
optimal at that node.
$26.416
$0.000

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 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 with h = 1)
• The second-period nodes are computed as follows
√
Su = $41e0.08×1/3+0.3 1/3 = $50.071
√
0.08×1/3−0.3 1/3
Sd = $41e = $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 (3)
• The option price is $7.074

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 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)

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 Put Options (cont’d)
• A binomial tree for a European put option with 1-year to
expiration $74.678
$0.000
Binomial tree for
pricing a European $61.149
$0.000
∆=0.000
put option; assumes B=$0.000
S = $41.00, K =
$50.071
$40.00, σ = 0.30, r = $0.741 $52.814
∆=–0.078 $0.000
0.08, T = 1.00 year, B=$4.659
$41.000 $43.246
δ = 0.00, and $2.999 $1.401
∆=–0.294 ∆=–0.171
h = 0.333. At each B=$15.039 B=$8.809

node the stock price, $35.411

option price, ∆, and $5.046
∆=–0.550 $37.351
B are given. Option B=$24.517 $2.649

prices in bold italic $30.585

$8.363
signify that exercise is ∆=–1.000
B=$38.947
optimal at that node.
$26.416
$13.584

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 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 (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∗ )])
• For an American put, the value of the option at a node is
given by
P (S, K, t) = max(K − S, e−rh [P (uS, K, t + h)p∗ +
P (dS, K, t + h)(1 − p∗ )])
38 / 52
 American Options (cont’d)

• The valuation of American options proceeds as follows

• At each node, we check for early exercise
• If the value of the option is greater when exercised,
we assign that value to the node. Otherwise, we
assign the value of the option unexercised
• We work backward through the three as usual

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 American Options (cont’d)
• Consider an American version of the put option valued in the
previous example $74.678
$0.000
Binomial tree for
pricing an American $61.149
$0.000
∆=0.000
put option; assumes B=$0.000
S = $41.00, K =
$50.071
$40.00, σ = 0.30, r = $0.741 $52.814
∆=–0.078 $0.000
0.08, T = 1.00 year, B=$4.659
$41.000 $43.246
δ = 0.00, and $3.293 $1.401
∆=–0.332 ∆=–0.171
h = 0.333. At each B=$16.891 B=$8.809

node the stock price, $35.411

option price, ∆, and $5.603
∆=–0.633 $37.351
B are given. Option B=$28.018 $2.649

prices in bold italic $30.585

$9.415
signify that exercise is ∆=–1.000
B=$38.947
optimal at that node.
$26.416
$13.584

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 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 more valuable than the
otherwise equivalent European option

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 Options on Other Assets

• The model developed thus far can be modified easily to

price options on underlying assets other than non
dividend-paying stocks
• The difference for different underlying assets is the
construction of the binomial tree and the risk-neutral
probability
• We examine options on
• Stock indexes
• Commodities
• Currencies
• Bonds
• Futures contracts

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 Options on a Stock Index
• Suppose a stock index pays continuous dividends at the
rate δ
• The procedure for pricing this option is equivalent to that
of the first example, which was used for our derivation.
Specifically

Cu − Cd
∆ = e−δh
S(u − d)
uCd − dCu
B = e−rh
u−d
(r−δ)h
e −d
p∗ =
u−d
• the up and down index moves are given by equation (10)
• the option price by equation (5)
43 / 52
A binomial tree for an American call option on a
stock index
$187.747
Binomial tree for $2.649
pricing an American
$157.101
call option on a stock $57.101
∆=0.988
index; assumes B=–$98.347
S = $110.00, K =
$131.458
$100.00, σ = $33.520 $132.779
∆=0.911 $32.779
0.30, r = 0.05, T = B=–$86.185
$110.000 $111.106
1.00 year, δ = 0.035, $18.593
∆=0.691
$14.726
∆=0.833
and h = 0.333. At B=-$57.408 B=–$77.871

each node the stock $92.970

$6.616
price, option price, ∆, ∆=0.447 $93.904
B=–$34.984 $0.000
and B are given.
Option prices in bold $78.576
$0.000
italic signify that ∆=0.000
B=$0.000
exercise is optimal at
that node.
$66.411
$0.000

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 Options on Currency

• With a currency with spot price x0, the forward price is

F0,t = x0 e(r−rf )t

Where rf is the foreign interest rate


• Thus, we construct the binomial tree using
√
ux = xe(r−rf )h+δ h
√
dx = xe(r−rf )h−δ h

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 Options on Currency (cont’d)

• Investing in a “currency” means investing in a

money-market fund or fixed income obligation
denominated in that currency
• Taking into account interest on the foreign-currency
denominated obligation, the two equations are

∆ × uxerf h + erh × B = Cu
∆ × dxerf h + erh × B = Cd

• The risk-neutral probability of an up move is

e(r−rf )h − d
p∗ =
u−d

46 / 52
 Options on Currency (cont’d)

• Consider a dollar-denominated American put option on

the euro, where
• The current exchange rate is $1.05/e
• The strike is $1.10/e
• The euro-denominated interest rate is 3.1%
• The dollar-denominated rate is 5.5%

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 Options on Currency (cont’d)
• The binomial tree for the American put option on the euro
$1.201
$0.000
Binomial tree for
pricing an American $1.148
$0.000
put option on a ∆=0.000
B=$0.000
currency; assumes
S = $1.05/e, K = $1.098
$0.021 $1.107
$1.10, σ = 0.10, r = ∆=–0.459 $0.000
B=$0.525
0.055, T = 0.50 year, $1.050 $1.058
$0.055 $0.042
δ = 0.031, and ∆=–0.774 ∆=–0.915
B=$0.867 B=$1.009
h = 0.167. At each
node the stock price, $1.012
$0.008
option price, ∆, and ∆=–0.995
B=$1.090
$1.020
$0.080
B are given. Option
$0.975
prices in bold italic $0.125
∆=–1.995
signify that exercise is B=$1.090
optimal at that node.
$0.940
$0.160
48 / 52
 Options on Futures Contracts

• Assume the forward price is the same as the futures price

• The nodes are constructed as
√ √
u = eσ h
d = e−σ h

• We need to find the number of futures contracts, ∆, and

the lending, B, that replicates the option
• A replicating portfolio must satisfy

∆ × (uF − F ) + erh × B = Cu
∆ × (dF − F ) + erh × B = Cd

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 Options on Futures Contracts (cont’d)
• Solving for ∆ and B gives
Cu − Cd
∆=
F (u − d)
 
1−d u−1
B=e −rh
Cu + Cd
u−d u−d

∆ tells us how many futures contracts to hold to

•
hedge the option, and B is simply the value of the
option
• We can again price the option using equation (3)
• The risk-neutral probability of an up move is given by

1−d
p∗ =
u−d
50 / 52
 Options on Futures Contracts (cont’d)

• Note that B is equal to the value of the option.

• B is positive, which means we are lending.
• In constructing the replicating portfolio, there is no
investment required to enter a futures contract – in each
period a futures contract pays the change in the futures
price.
• The motive for early-exercise of an option on a futures
contract is the ability to earn interest on the
mark-to-market proceeds
• When an option is exercised, the option holder pays
nothing, is entered into a futures contract, and
receives mark-to-market proceeds of the difference
between the strike price and the futures price

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A tree for an American call option on a gold
futures contract
$356.733
Binomial tree for $56.733
pricing an American
call option on a $336.720
$36.720
∆=1.000
futures contract; B=$36.720
assumes
$317.830
S = $300, K = $21.843 $311.830
∆=0.768 $11.830
$300, σ = 0.10, r = B=$21.843
$300.000 $300.000
0.05, T = 1.00 year, $12.488 $8.515
∆=0.513 ∆=0.514
δ = 0.05, and B=$12.488 B=$8.515

h = 0.333. At each $283.170

node the stock price, $4.066
∆=0.260 $283.170
option price, ∆, and B=$4.066 $0.000

B are given. Option $267.284

$0.000
prices in bold italic ∆=0.000
B=$0.000
signify that exercise is
optimal at that node.
$252.290
$0.000
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