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+
+ +
+
that can be applied at any time T-1 to determine the price of the option as a function of
its value at time T.
2.1 The Discrete Time Model
From the above equation, the value of a call option at maturing date T-1 is given by
1
(1 ) ( (1 ))
( )(1 )
T T
T
W R H W H R
W
H H R
+ +
+
+ + +
+
(2.1)
Similarly,
1 1
2
(1 ) ( (1 ))
( )(1 )
T T
T
W R H W H R
W
H H R
+ +
+
+ + +
+
(2.2)
Substituting (2.1) into (2.2) can get,
2 2 2
( (1 ) ( (1 )))(1 )
( ) (1 )
T T
T
W R H W H R R H
W
H H R
++ + +
+
+ + + +
+
2 2
( (1 ) ( (1 )))( (1 ))
( ) (1 )
T T
W R H W H R H R
H H R
+ + +
+
+ + + + +
+
+
(2.3)
Noting that
T T
W W
+ +
, so (2.3) can be simplified as:
2 2
2 2 2
( (1 ) 2 ( (1 )))(1 ) ( (1 ))
( ) (1 )
T T T
T
W R H W H R R H W H R
W
H H R
++ + + +
+
+ + + + + +
+
(2.4)
3
We can use this recursive form to get
0
W
:
Since after T periods, there are
0
T _
,
ways that a sequence of (T) pluses can occur,
1
T _
,
ways that (T-1) pluses can occur,
2
T _
,
ways that (T-2) pluses can occur, and so
on.
Hence, by Binomial Theorem
0
W
can be represented as:
0
W
...... 0
...... 1 1
..... 2 2
.... 1 1
...... 0
[ (1 ) ( (1 ))
0
(1 ) ( (1 ))
1
(1 ) ( (1 ))
2
(1 ) ( (1 ))
1
(1 ) ( (1
T
T
T
T
T
T
T
T
T
T
W R H H R
T
W R H H R
T
W R H H R
T
W R H H R
T
T
W R H H
T
+ + +
+ +
+ +
+ +
+
_
+ +
,
_
+ + +
,
_
+ + +
,
_
+ + +
,
_
+ + +
,
M
)) ]
[( )(1 )]
T
T
R
H H R
+
+
(2.5)
Next to determine the value of the option at maturity. Suppose that stock increases i
times and declines
( ) T i
times, then the price of the stock will be
0
i T i
S H H
+
on the
expiration date. So the option will be exercised if
4
0
i T i
S H H X
+
>
The maturity value of the option will be
0
i T i
T
W S H H X
+
(2.6)
Let
a
denote the minimum integer value of i in (2.6) for which the inequality is
satisfied.
0
ln( ) ln( )
1
ln ln
X
T H
S
a INT
H H
+
1
1
+
1
1
]
(2.7)
where
[ ] INT
is the integer operator.
i.e., taking natural logarithm of RHS of (2.6),
0
0
0
ln ln ( ) ln ln
ln ln ln( ) ln
ln( ) ln
ln ln
S i H T i H X
X
i H i H T H
S
X
T H
S
i
H H
+
+
+
+ +
+
<
K K
K K
(2.8)
Substituting (2.8) into (2.5), then the generalized option pricing equation for the
5
discrete time is
0
0
( )(1 ) ( (1 ))
( ) (1 )
i T i
T
i T i
i a
T T
T
S H H X R H H R
i
W
H H R
+ +
+
_
+ +
,
(2.9)
2.2 The Continuous Time Model
For (2.9), we can write is as:
0
0
0
( )(1 ) ( (1 )) (1 ) ( (1 ))
( ) (1 )
[ (1 )] [ ( 1 )]
( ) (1 )
(1 ) ( (1 ))
(
i T i
T T
i T i i T i
i a i a
T T
T
i T i
i a
T T
T
i T i
i a
T T
S H H R H H R X R H H R
i i
W
H H R
T
S H R H H H R
i
H H R
T
X R H H R
i
H
+ + +
+
+ +
+
+
+
_ _
+ + + +
, ,
+
_
+
,
+
_
+ +
,
0
) (1 )
(1 ) ( 1 )
(1 )( ) ( )(1 )
(1 ) ( 1 )
(1 ) ( ) ( )
T T
i T i
T
i a
i T i
T
T
i a
H R
T
R H H H R H
S
i R H H H H R
T
X R H H R
i R H H H H
+ +
+ +
+
+ +
+
1 1 _ +
1 1
+ +
, ] ]
1 1 _ +
1 1
+
, ] ]
(2.10)
Since
(1 )
(1 )( )
R H H
R H H
+
+
+
+
+
( 1 )
1
( )(1 )
H R H
H H R
+
+
+
,
(1 ) ( 1 )
1
( ) ( )
R H H R
H H H H
+
+ +
+
+
,
therefore, can interpret it as pseudo probability.
Let
(1 )
(1 )( )
R H H
R H H
+
+
+
+
and
(1 )
( )
R H
H H
+
+
+
(2.13)
Let
1
r
T
R e +
, then
lim(1 )
T r
T
R e
+
. And since 1 2
lim lim
T T
Z Z
, the remaining
things to be determined are 1
lim
T
Z
and 2
lim
T
Z
.
From equation (10) and (11) of the text in the Rendleman and Bartter (1979),
7
(1 )
( )
( )
(1 )
T
T
T
T
H e
H e
+
+
substituting
H
+
and
H
into (2.7), so
0
1
ln( )
1
1
(1 )
(1 ) (1 )
X
T
S
INT T
T
a T
Z
T T
1
+
1
1
+
1
1
]
In the limit, the term
1 [ ] INT +
will be simplify to
[ ]
. So,
0
1
0
0
0
ln( )
1 1
1
(1 ) (1 )
(1 ) (1 )
ln( )
1
1
(1 ) (1 ) (1 )
(1 )
(1 )
ln( )
1
(1 ) (1 ) (1 )
(1 )
(1 )
ln( )
(1 )
1
(1 )
(1 )
X
T
S
Z
T T
T T
X
T
S T
T T
T
X
T
S T
T T
T
X
T T
S
T
:
:
:
:
0
(1 ) (1 )
ln( )
( )
(1 ) (1 )
(1 )
T
T
X
S T
:
(2.14)
8
Substituting
H
+
,
H
and
1
r
T
R e +
into
,
1
( ) ( )
1
1
( ) ( )
1
1
( ) ( )
1
1
( ) ( )
1
1 1
( ) ( ) ( )
1
(1 )
(1 )( )
r
T T T T T
r
T T T T T
r
T T T T
r
T T
T
r
T T T T T
R H H
R H H
e e e
e e e
e e e
e e e
e e
+
+
+
1
1
1
]
1
1
1
]
1
1
1
]
1
1
1
]
1
( ) ( )
1
1 1
( ) ( )( )
1
1 1
( ) ( ) ( ) ( )
1 1
T T
r
T T T T
T T T T
e e
e e
e e e e
1
1
1
]
1
1
1
]
1 1
1 1
1 1
] ]
1 1
1 1
1 1
] ]
Now expanding in Taylors series in T,
9
2 2
2 2
2
1
( )
1
1 1 1 1
( ) ( ) ( )
1 2 1
1 1
( ) ( )
2 1
1 1 1 1
( ) ( ) ( )
1 2 1
1
( )
1
2 1
1 1 1 1
( ) ( )( ) ( )
1 2 1
1
1 1
( ) ( )(
1 2
T o
T
T o
T T
r O
T
T o
T T
r
T
o
T T
T
1
+ + +
1
]
+ +
+
1
+ + +
1
]
+
+ + +
+ +
1
( )
1 1
) ( )
1
o
T
o
T
+
1
+
1
]
where,
2
3
2
1 1 1
1
2!
1 1
3!
1 1 1
1
2
H
T T
T T
T T
o
T T T T
+
_ _
+ + + +
, ,
_
+ + +
,
_ _
+ + + +
, ,
L
and
2
3
2
1
1
1 2! 1
1
3! 1
1
1
1 2 1
H
T T
T T
T T
o
T T T T
_ _
+ +
, ,
_
+ +
,
_ _
+ + + +
, ,
L
10
where
1
( ) o
T
denotes a function tending to zero more rapidly than
1
T
.(when we
expanding in Taylors series in T, the rest of the terms tending to zero more rapidly than
1
T
so regard them as a function
1
( ) o
T
.) Hence,
2
1 1
lim (1 )
1
1
1
(1 )
1
T
and,
11
2 2
2
2 2
2
lim ( )
1
( )
1
2 1
lim [
1 1 1 1
( ) ( )( ) ( )
1 2 1
1
1
( )]
1 1 1 1
( ) ( )( ) ( )
1 2 1
1
( )
2 1
lim[
1 1 1 1
( ) ( )( ) ( )
1 2 1
T
T
T
T
r
T
T
o
T T
o
T
o
T T
r
T
o
T
T
T
+ + +
1
+ + +
1
]
+
+ + +
2
2
2 2
2
1
1
( )]
1 1 1 1
( ) ( )( ) ( )
1 2 1
1 1 1 1
( ) ( )( ) ( )
1 2 1 1
lim
1 1 1 1
( ) ( )( ) ( )
1 2 1
1
( )
2 1
1 1 1
( ) ( )( ) (
1 2 1
T
To
T
o
T
T
T o T
T T
o
T T
r
o
T
1
+ + +
1
]
1
+ + +
1
]
+ + +
+
+ + +
2 2 2
2 2
2 2 2
2 2 2
2 2 2 2
1
( )
1
)
1 1 1
( ) ( ( ) )
2 1 2 1
1
( )
1
1 (1 ) 1
( ) ( )
2 (1 ) 2 1
1
(1 )
1 1 2 1
( ) ( )
2 1 2 1
1
(1 )
1 1 1 1
( ) ( ) ( )
2 1 2 1 2 1
1
(1 )
To
T
T
r
r
r
r
+ +
+ +
+ +
12
After canceling terms,
2
1
(1 )( )
2
lim ( )
T
r
T
+
Now substituting
lim
T
for
and
lim ( )
T
T
Similarly,
2
0
2
1
ln( )
2
lim
T
X
r
S
Z
Since
( , ) ( , ) N Z N Z
, let 1 1
lim
T
D Z
, 2 2
lim
T
D Z
, the continuous time
version of the two-state model is obtained:
0 0 1 2
2
0
1
2 1
( , ) ( , )
1
ln( )
2
r
w S N D Xe N D
X
r
S
D
D D
+ +
The above equation is identical to the Black-Scholes model.
13
3. The Binomial Option Pricing Model of Cox, Ross and Rubinstein
In this section we will concentrate on the limiting behavior of the binomial option
pricing model proposed by Cox, Ross and Rubinstein (CRR, 1979).
3.1 The Binomial Option Pricing Formula of CRR
Let S be the current stock price, K the option exercise price, 1 R the riskless rate. It
is assumed that the stock follows a binomial process, from one period to the next it can
only go up by a factor of
u
with probability
p
or go down by a factor of d with
probability
) 1 ( p
. After n periods to maturity, CRR showed that the option price C is:
. ] , 0 [ ) 1 (
)! ( !
! 1
0
n
k
k n k k n k
n
K S d u Max p p
k n k
n
R
C
(3.1)
An alternative expression for C, which is easier to evaluate, is
). , ; ( ) , ; (
] ) 1 (
)! ( !
!
[ ] ) 1 (
)! ( !
!
[
p n m B
R
K
p n m SB
p p
k n k
n
R
K
R
d u
p p
k n k
n
S C
n
n
m k
k n k
n
n
m k
k n k
k n k
(3.2)
where
) 1 ( ) , ; (
n
m k
k n k
k n
p p C p n m B
and m is the minimum number of upward
stock movements necessary for the option to terminate in the money, i.e., m is the
14
minimum value of k in (3.1) such that 0. X - S d
m - n m
> u
3.2 Limiting Case
We now show that the binomial option pricing formula as given in Equation (3.2) will
converge to the celebrated Black-Scholes option pricing model. The Black-Scholes
formula is
) ( ) (
1 1
t d N X e d N S C
rt
(3.3)
where
2
) log(
1
t
t
XR
S
d
t
+
(3.4)
2
= the variance of stock rate of return
t = the fixed length of calendar time to expiration date, such that
n
t
h .
We wish to show that Equation (3.2) will coincide with Equation (3.3) when
n
.
In order to show the limiting result that the binomial option pricing formula
converges to the continuous version of Black-Scholes option pricing formula, we
suppose that h represents the lapsed time between successive stock price changes.
Thus, if t is the fixed length of calendar time to expiration, and n is the total number of
15
periods each with length h, then
n
t
h . As the trading frequency increases, h will get
closer to zero. When 0 h , this is equivalent to
n
.
Let
R
be one plus the interest rate over a trading period of length h. Then, we will
have
t T
R R
(3.5)
for any choice of n. Thus,
n
t
R R
as
n
.
Let S
*
be the stock price at the end of the nth period with the initial price S. If there
are j up periods, then
d n
d
u
j d j n u j
S
S
log ) log( log ) ( log log
*
+ + (3.6)
where j is the number of upward moves during the n periods.
Since j is the realization of a binomial random variable with probability of a success
being q, we have expectation of log (S
*
/S)
, ] log ) log( [ ) (log
*
n n d
d
u
q
S
S
E + (3.7)
and its variance
16
. ) 1 ( )] [log( ) (log
2 2
*
n n q q
d
u
S
S
Var (3.8)
Since we divide up our original longer time period t into many shorter subperiods of
length h so that hn t , our procedure calls for making n longer, while keeping the
length t fixed. In the limiting process we would want the mean and the variance of the
continuously compounded log rate of return of the assumed stock price movement to
coincide with that of actual stock price as
n
. Let the actual values of
n
and
n
2
respectively. Then we want to choose u, d, and q in such a manner that
t n
and t n
2 2
as
n
. It can be shown that if we set
,
n
t
e u
,
n
t
e d
(3.9)
,
2
1
2
1
n
t
q
,
_
then
t n
and t n
2 2
as
n
. In order to proceed further, we need the
following version of the central limit theorem.
Lyapounovs Condition. Suppose , ,
2 1
X X are independent and uniformly bounded
with
0 ) (
i
X E
,
,
1 n n
X X Y + +
and ). ( ) (
2 2
n n
Y Var Y E s
17
If
0
1
lim
1
2
2
+
+
n
k
k
n
n
X E
s
for some
, 0 >
then the distribution of
n
n
s
Y
converges to
the standard normal as
n
.
Theorem 1. If
3 3
3
log (1 ) log
0 as
p u p d
n
n
+
(3.10)
then
) (
) log(
Pr
*
z N z
n
n
S
S
1
1
1
1
]
1
(3.11)
where N(z) is the cumulative standard normal distribution function.
Proof. See Appendix.
It is noted that the condition (3.10) is a special case of the Lyapounovs condition
which is stated as follows. When
, 1
we have the condition (3.10).
This theorem says that when the fixed length t is divided into many subperiods, the
log rate of return will approach to the normal distribution when the number of
subperiods approached infinity. For this theorem to hold, the condition stated in
Equation (3.10) has to be satisfied. We next show that this condition is indeed satisfied.
We will next show that the binomial option pricing model as given in Equation (3.2)
18
will indeed coincide with the Black-Scholes option pricing formula as given in
Equation (3.3). Observe that
n
R
is always equal to
t
R
(3.12)
Recall that we consider a stock to move from S to uS with probability p and dS with
probability (1-p). During the fixed calendar period of t=nh with n subperiods of length
h, if there are j up moves, then
d n
d
u
j
S
S
log ) log( log
*
+ . (3.13)
The mean and variance of the continuously compounded rate of return for this stock
are
P
and
2
P
where
19
d
d
u
p
P
log ) log( + and ) 1 ( )] [log(
2 2
p p
d
u
P
.
From Equation (3.13) and the definitions for
P
and
2
P
, we have
n
n
S
S
p np
np j
P
P
) log(
) 1 (
*
. (3.14)
Also, from the binomial option pricing formula we have
, log / ] log [log
) log(
) log(
1
d
u
d n
S
X
d
u
Sd
X
m
n
where is a real number between 0 and 1.
From the definitions of
P
and
2
P
, it is easy to show that
.
) log( ) log(
) 1 (
1
n
d
u
n
S
X
p np
np m
P
P
Thus from Equation (3.12) we have
).
) log( log
log
Pr( ) , ; ( 1
*
n
d
u
n
S
X
n
n
S
S
p n m B
P
P
P
P
(3.15)
20
We will now check the condition given by Equation (3.10) in order to apply the
central limit theorem. Now recall that
d u
d r
p
,
with
n
t
r r
, and d and u are given in Equation (3.9).
We have
log
3
2
2
3
2
2
1
1
1 log [1 ] ( )
2
1 [1 ] ( )
1
log
1 1
2
[ ] ( ). (3.16)
2 2
t t
r
n n
t t
n n
e e
p
e e
t t t
r O n
n n n
t t
O n
n n
r
t
O n
n
+ + +
+ +
+ +
Hence, the condition given by Equation (10) is satisfied because
. as , 0
) 1 (
) 1 (
| log | ) 1 ( | log |
2 2
3
3 3
+
n
p np
p p
n
d p u p
p
p p
Finally, in order to apply the central limit theorem, we have to evaluate
n
p
,
n
p
2
and ) log(
d
u
as
. n
It is clear that
21
t n t r n
p p
2 2 2
, )
2
1
(log and 0 ) log(
d
u
.
Hence, in order to evaluate the asymptotic probability in Equation (3.12), we have
.
)
2
1
(log ) log(
) log( ) log(
2
t
t r
S
X
z
n
d
u
n
S
X
p
p
Using the fact that
) ( ) ( 1 z N z N
, we have, as
n
). ( ) ( ) , ; ( t x N z N p n m B
Similar argument holds for
) ' , ; ( p n m B
, and hence we completed the proof that the
binomial option pricing formula as given in equation (3.2) includes the Block-Scholes
option pricing formula as a limiting case.
4. Comparison of the Two Approaches
From the results of last two sections, we show that both RB and CRR models lead to
the celebrated Black-Scholes formula. The following table shows the comparisons of
the necessary mathematical and statistical knowledge and assumptions for the two
models.
Model Rendleman and Bartter (1979) Cox, Ross and Rubinstein (1979)
22
Mathematical
and
Probability
Theory
Knowledge
Basic Algebra
Taylor Expansion
Binomial Theorem
Central Limit Theorem
Properties of Binomial Distribution
Basic Algebra
Taylor Expansion
Binomial Theorem
Central Limit Theorem
Properties of Binomial Distribution
Lyapounovs Condition
Assumption 1. The distribution of returns of the
stock is stationary over time and the
stock pays no dividends.(Discrete
Time Model)
2. The mean and variance of
logarithmic returns of the stock are
held constant over the life of the
option.(Continuous Time Model)
The stock follows a binomial process
from one period to the next it can
only go up by a factor of u with
probability p or go down by a
factor of d with probability 1-p.
In order to apply the Central Limit
Theorem, u, d, and p are
needed to be chosen.
Advantage
and
Disadvantage
1. Readers who have undergraduate
level training in mathematics and
probability theory can follow this
approach.
2. The approach of RB is intuitive.
But the derivation is more
complicated and tedious than the
approach of CRR.
1. Readers who have advanced level
knowledge in probability theory can
follow this approach; but for those
who dont, CRR approach may be
difficult to follow.
2. The assumption on the parameters
u, d, p makes CRR approach
more restricted than RB approach.
Hence, like we indicate in the table, CRR is easy to follow if one has the advanced
level knowledge in probability theory but the assumptions on the model parameters
make its applications limited. On the other hand, RB model is intuitive and does not
require higher level knowledge in probability theory. However, the derivation is more
complicated and tedious.
For readers who are interested in the binomial option pricing model, they can
compare the two different approaches and find the best one which fits their interests and
is easier to follow.
23
Appendix
The Binomial Theorem
0
( )
n
n k n k
k
n
x y x y
k
_
+
,
and
finite variance
2
and
1
1
( )
n
i
i
x x
n
, then
2
( ) 0,
d
n
n x N 1
]
Proof of Theorem 1.
Since
3 3
3
3
log log log log (1 ) log
u u
p u p u p d p p
d d
And
3 3
3
3
(1 ) log (1 ) log log log (1 ) log ,
u u
p d p d p d p p
d d
24
We have
3
3 3
2 2
log (1 ) log (1 )[(1 ) ] log
u
p u p d p p p p
d
+ .
Thus
3 3
3
3
2 2
3
2 2
log (1 ) log
(1 )[(1 ) ] log
( (1 ) log( ))
(1 )
0 as .
(1 )
p u p d
n
u
p p p p
d
u
p p n
d
p p
n
np p
Hence the condition for the theorem to hold as stated in Equation (3.10) is satisfied.
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