Академический Документы
Профессиональный Документы
Культура Документы
BINOMIAL MODEL
The stock of a company is currently quoted in the market at Rs.150. The price of the stock is expected to go
up or down by 10% in next one year and by 15% in the second year. The risk-free interest rate in the
economy is 6%.
Required:
Using two-step Binomial Model, find out the price of a 2-year American put option on the company’s
stock with strike price of Rs.175.
SOLUTION
Current stock price = Rs.150
Price after first year = ± 10%
Price after second year = ± 15%
Risk-free rate = 6%
The situation can be represented in the following way:
The value of American put option at node D, E, F and G will be equal to the value of European put
option on these nodes.
Value at node D : as put is out-of-money, so value is zero
Value at node E : 175 – 140.25 = 34.75
Value at node F : 175 – 155.25 = 19.75
Value at node G : 175 – 114.75 = 60.25
1.06 − 0.85
1.15 − 0.85
Probability of price increase in second year, P2 = = 0.70
Probability of price decrease = 1 – P2 = 0.3
Using single-period model, the value of put at node B is
Pu p 2 + Pd (1 − p 2 )
P = R
0 × 0.70 + 34.75 × 0.30
= 1.06 = 9.83
At node B, pay-off from early exercise is Rs.10, which is more than the value calculated as per single-
period model. So value of put at node B is 10.
The value of put at node C is
19.75 × 0.70 + 60.25× 0.30
P = 1.06 = 30.09.
Pay-off from early exercise is 40, whereas single-period model gives a value of 30.09 which is lower,
so value of put will be 40.
1.06 − 0.90
Probability of price increase in first year, p1 = 1.10 − 0.90 = 0.80.
Probability of price decrease = 1 – p1 = 0.20.
The value of put at mode A,
10 × 0.80 + 40 × 0.20
P = 1.06 = 15.09.
Whereas the value due to early exercise is Rs.25 which is more than the value given by single period
model.
Hence, the value of two year American put option is Rs.25.