Introduction

 A binomial tree is a diagram showing the different

possible paths that stock prices may take over the life
span of an option.
They are used in calculating the prices of an option
based.
 They assume that stock prices take a random walk i.e.
at any given time there is a probability that the price
will either increase or drop by a certain percentage.
A One Step Binomial Model & A No-arbitrage
argument
 This is best explained by the example below ;
Example 1;If the current stock price is $ 20 and at the end of 3 months, it will either be
$22 or $18. The investor wants to value the call option of buying the stock at $21 in 3
months.
 If the price turns out as 22, the value of the option will be 1 (22-21= 1)
 If the price turns out as 18 the value will be 0 (18-21 = -3)
 This can be illustrated as;
Stock price = 22 (value is 1)

Stock price =20

Stock price =18 (value is0)

 This scenario assumes no arbitrage opportunities.

A One Step Binomial Model & A No-arbitrage
argument Cont’d
 Determining the riskless portfolio
Example 2: Considering example 1, the investor takes a portfolio with
a long position in “∆” shares of the stock and a short on one call option.
Calculate the value that makes the portfolio riskless.
Price changes Share value Option Value Portfolio value
Increases to 22 22∆ 1 22∆-1
Reduces to 18 18∆ 0 18∆

The portfolio will be riskless if the value of “∆” results into the
portfolio value being equal at both price movement levels
22∆-1=18∆
∆= 0.25
This implies that a riskless portfolio is taking a short position 1 call
option and a long position of 0.25shares.
This means that no matter the movement of the stock price the portfolio
value will remain 4.5 (18 x 0.25 or (22 x 0.25)-1).
A One Step Binomial Model & A No-arbitrage
argument Cont’d
Present Value of the option
 In the absence of arbitrage opportunities, riskless portfolios earn the risk
free interest rate.
 Referring to example 2, suppose the risk free rate is 12%. The present value
of the portfolio will be;
3
4.5𝑒 −0.12× Τ12 =4.367
 The current value of the option price will be as below if the stock price
today is 20;
Let the current value of the option price be “f”
At riskless the value will be (20 x 0.25) – f= 4.367
f= 0.633 (this is the set price of the option)
 This indicates that if the current value of the option was more than 0.633,
the portfolio will cost less than 4.367 to set up and will earn more than 12%
 Generalization of the no- arbitrage argument
Consider a stock whose price is “S” and an option whose
current price is “f ”. The assumptions are;
 the option lasts for time “ t”
 the stock prices can either move up to “Su” where u > 1
 or move down to “ Sd ” where d < 1
 the percentage changes in the stock price “S” are u-1 and 1-d
respectively.
 the payoffs due to price changes are “ fd ” and “fu” respectively
 Generalization of the no- arbitrage argument cont’d
 Considering a portfolio with a long position of “∆” shares and a
short position in 1 option. What value of “∆” makes the portfolio
riskless.
 For an increase in stock price the portfolio value at the end of the
option life time is Su.∆- fu
 For a decrease the portfolio value is Sd.∆- fd
 Therefore the riskless position will be ;
Su.∆-fu = Sd.∆-fd
∆= fu – fd
Su- Sd
 Therefore ∆ is the ratio of the change of the option price to the
change in the stock price as movement is made between the
different time points.
 Illustration of the generalization of the no- arbitrage
argument
Su.f

S.f
Sd.f
 On factoring in the risk free interest rate “ r”;
−𝑟𝑇
 the present value of the portfolio will be (𝑆𝑢. ∆ − 𝑓𝑢)𝑒
 the cost of setting up the portfolio will be S. ∆ –f where 𝑓 = 𝑆. ∆(1 −
−𝑟𝑡 𝑒 −𝑟𝑡
𝑢𝑒 )+𝑓𝑢
 the present value of the option price “f” will be
𝑓 = 𝑒 −𝑟𝑇 (𝑝𝑓𝑢 +(1 − 𝑝)𝑓𝑑 )
 And the probability “p” of an upward rising of the stock price S is
𝑒 −𝑟𝑡 − d
𝑝=
𝑢−𝑑
 The equations above enable the pricing of options when stock price movements
are given by a one step binomial tree and only assume no arbitrage opportunities.
 Risk-neutral valuation
 It is assumed that investors are risk-neutral when valuing a
derivative i.e the expected return required from an investment is not
increased so as to compensate for the increased risk.
 Despite of the real world not being risk free, the assumption of a
risk-neutral world aids in calculating the right option price for the
real world.
 Key considerations under risk-neutral valuation
 Expected return on an investment is the risk free rate
 Discount rate used for expected pay off of a derivative is the risk free
rate.
 In a risk-neutral world,
 the expected future payoff from an option is represented by;
𝑃𝑓𝑢 + 1 − 𝑃 𝑓𝑑
Where “P” is the probability of an up movement
1-P is the probability of a down movement in a risk neutral world.
 Risk-neutral valuation cont’d
 Expected stock price E(𝑠𝑡 ) = PSu + Sd(1-P) or E(𝑆𝑡 )= 𝑆𝑒 𝑟𝑡
 Averagely stock price grows at the risk free rate when “P” is
the probability of an up movement.
The risk-neutral valuation is applied by calculating the
probabilities of the different outcomes in the risk-neutral
world, calculation of the expected payoff and then the
expected pay off is discounted at the risk free rate.
Example; the stock price is currently $20 and will move
either up to $22 or down to $18 at the end of 3 months. The
option considered is a European call option with a strike price
of $21 and an expiration date in 3 months. The risk-free
interest rate is 12% per annum.
 Risk-neutral valuation cont’d
 It can be argued that the expected return on the stock in a risk
neutral world is the risk free rate of 12% , therefore “P” can be got
from
3
0.12×
22𝑃 + 18 1 − 𝑃 = 20𝑒 12

4P = 20𝑒 0.03 -18

P= 0.6523
 This implies that at the 3 months end period ,the call option has a
0.6523 chance of being valued at 1 or a 0.3477 chance of being 0.
 Expected value is; E(𝑆𝑡 )= PSu + Sd(1-P) =0.6523× 1 + 0.3477 ×
0 = 0.6523
3
−0.12×12
 On discounting; 0.6523𝑒 = 0.633
 The answer above is the same as one obtained earlier (refer to slide
5) which is an indication that no arbitrage arguments and risk
neutral valuation give the same answer.
 Risk-neutral valuation cont’d
 Real world vs Risk neutral world
The probability of movement in the real world is not the same as
that in the risk free world since the real world there is a different
expected rate of return.
For instance if the expected return was 16% and 𝑃∗ was the
probability in the real world.
22𝑃∗ + 18(1-𝑃∗ )= 20𝑒 0.16×3/12
𝑃∗ =0.7041
The expected pay off in the real world is given by
𝑃∗ × 1 + (1 − 𝑃∗ ) × 0
 Two step Binomial trees
 Assume the stock price starts at $20 and it Stock price
may either rise/fall by 10%. The risk free  D 1.1 x 22 = 24.2
interest rate is 12% per annum and a 6  E 1.1 x 18 = 19.8
month option is considered with a strike
balance of $21.The objective is to find the  F 18 x 0.9 = 16.2
option price at the initial node of the tree Option price
(A).  D 24.2-21= 3.2
 E and F the option is out of money &
value is 0
 C is 0 because the node leads to E & F
 B
u=1.1, d= 0.9, r =0.12, T =0.25, p=0.6523
𝑓 = 𝑒 −𝑟𝑇 (𝑝𝑓𝑢 +(1 − 𝑝)𝑓𝑑 )
3
𝑒 −0.12× ൗ12 0.6523 × 3.2 + 0.3477 × 0
= 2.0257
 A
Using the same equation as at node B
above option price at A is 1.2823
Generalization of the 2 binomial tree
 Alternatively, the formula below may be used to find the
option price at node A
𝑓 = 𝑒 −2𝑟∆𝑡 [𝑝2 𝑓𝑢𝑢 + 2𝑝 1 − 𝑝 𝑓𝑢𝑑 + (1 − 𝑝)2 fdd]
Where ;
 𝑓𝑢𝑢 is value of the option after 2 up movements
 fdd is the value of the option after 2 down movements
 𝑓𝑢𝑑 is the value of the option after a 1upmovement and 1
down movement or vice versa
A Put
 A put too can be priced using binomial
trees.
 Example; consider a 2-year European
Put with a strike balance of $52 on a
stock whose price is $50. Suppose that
there are two times steps of 1 year and
in each time step the stock price either
moves up/down by 20%. The risk free
rate is 5%.
u= 1.2 ((100+20)/100)
d= 0.8 ((100- 20)/100)
t= 1
r=0.05
As earlier seen the value of a−𝑟𝑡risk free
𝑒 −d
probability is given by 𝑝 =
𝑢−𝑑
𝑒 −0.05×1 −0.8
p= 1.2−0.8
=0.6282
American Option
 With this we work backward  Referring to the previous
through the tree from the end example,
to the beginning , testing at
each nodes to see whether
early exercise is optimal.
 The value of the option at
the final node is the same as
for the European
 At earlier nodes the value of
the option is greater of;
 The value given by equation
 The payoff from early
exercise
 Delta (∆)
 Is the ratio of the change in the price of the stock option to the
change in the price of the underlying stock.
It is the number of the units of the stock we should hold for
each option shorted in order to have a riskless portfolio(delta
hedging)
If the current stock price is $20. At the end of 3 months it will
either be $22 and the option price 1 or $18 and option price 0.
What is the value of the delta?
1−0
= 0.25 (this is the same as the delta calculated in example 1)
22−18
 Matching Volatility with u and d
 This explains whether when constructing a binomial tree, the
volatility to be matched is the one in the real world or the one
in the risk-neutral world.
However it should be noted that the volatility assumed is the
same in both the real and risk-neutral world
The volatility of a stock price is represented by 𝜎 and will be
𝜎 ∆𝑡 which is the standard deviation of the return on the
stock price in a short period of time of length ∆𝑡.
It follows that ;
 Increasing the number of steps
 In practice the life of an option is dividend into 30 or more time
steps.
 Regardless of the number of time steps the equations above still
hold for example that there are five steps instead of two in the
example before .
 The parameters would be;
2
 ∆𝑡 = = 0.4,
5
 𝑟 = 0.05
 𝜎 = 0.3
These values give;
 𝑢 = 𝑒 0.3× 0.4 =1.2089
 d=1/1.2089=0.8272 .
 a=𝑒 0.05×0.4 =1.0202
 p=(1.0202-0.8272)/(1.2089-0.8272)0.5056
 Options on other assets
 Options on stocks paying a continuous dividend yield;If a stock
is paying a known dividend yield at rate q, the total return in a risk
neutral world is r dividend provide a return of q and capital gains a
return of r-q. The formula for probability is;

the same applies for options on stock indices providing a dividend

yield at a rate of q.
 Options on currencies ; providing a yield at a foreign risk free
𝑒 (𝑟−𝑟𝑓)∆𝑡 −𝑑
rate of interest rf, will have a probability of 𝑝 =
𝑢−𝑑
Options on other assets cont’d
Options on futures; It costs nothing to take a long/short
position in a futures contract . In a risk neutral world a futures
price should have an expected growth rate of 0. ie r=0
1−𝑑
Thus p =
𝑢−𝑑
Practice Questions

Refer to textbook;
Qn 2,9,11,13,15,16,17 &19.
THE END
&
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