Call Option Binomial Trees

Shahed Ahmmed 20041

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Example
A stock price is currently Tk20 In 3 months it will be either Tk22 or Tk18

Stock Price = Tk22

Stock price = Tk20 Stock Price = Tk18

Call Option
A 3-month call option on the stock has a strike price of 21.
Stock Price = Tk22 Option Price = Tk1
Stock price = Tk20 Option Price=? Stock Price = Tk18 Option Price = Tk0

How to make a Riskless Portfolio

In the Portfolio:

long D shares short 1 call option

22D 1

18D

Portfolio is riskless when 22D 1 = 18D or

D = 0.25
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Delta
Delta (D) is the ratio of the change in the price of a stock option to the change in the price of the underlying stock The value of D varies from node to node

Choosing u and d
One way of matching the volatility is to set
u es
Dt Dt

d 1 u e s

where s is the volatility and Dt is the length of the time step. This is the approach used by Cox, Ross, and Rubinstein

Valuing the Portfolio

(Risk-Free Rate is 12%)

The riskless portfolio is: long 0.25 shares short 1 call option The value of the portfolio in 3 months is 22 0.25 1 = 4.50 The value of the portfolio today is 4.5e 0.120.25 = 4.3670

Valuing the Option

The portfolio that is long 0.25 shares short 1 option is worth 4.367 The value of the shares is 5.000 (= 0.25 20 ) The value of the option is therefore 0.633 (= 5.000 4.367 )

Generalization
A derivative lasts for time T and is dependent on a stock

S0

S0u u S0d d
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Generalization (continued)

Consider the portfolio that is long D shares and short 1 derivative S0uD u S0dD d The portfolio is riskless when
S0uD u = S0dD d or

u f d D S 0u S 0 d
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Generalization (continued)
Value of the portfolio at time T is S0uD u Value of the portfolio today is (S0uD u)erT Another expression for the portfolio value today is S0D f Hence = S0D (S0uD u )erT

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Generalization
(continued)

Substituting for D we obtain = [ pu + (1 p)d ]erT where

e d p ud
rT
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p = 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

S0

S0u u S0d d
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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 riskfree rate and discount at the risk-free rate This is known as using risk-neutral valuation

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Example
S0u = 22 u = 1 S0

S0d = 18 d = 0

Since p is the probability that gives a return on the stock equal to the risk-free rate. We can find it from 20e0.12 0.25 = 22p + 18(1 p ) which gives p = 0.6523 Alternatively, we can use the formula

e rT d e 0.120.25 0.9 p 0.6523 ud 1.1 0.9

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Valuing the Option Using Risk-Neutral Valuation

S0u = 22 u = 1 S0 S0d = 18 d = 0

The value of the option is e0.120.25 (0.65231 + 0.34770) = 0.633

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Stocks Expected Return is not a factor

When we are valuing an option in terms of the price of the underlying asset, the probability of up and down movements in the real world are irrelevant This is an example of a more general result stating that the expected return on the underlying asset in the real world is irrelevant
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Two step valuation of a Call Option

D

22 20 1.2823
A

24.2 3.2 19.8 0.0 16.2 0.0

B E

2.0257 18 0.0
C

Value at node B is e0.120.25(0.65233.2 + 0.34770) = 2.0257 Value at node A is e0.120.25(0.65232.0257 + 0.34770) = 1.2823
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Thank You.
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