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Chapter contents

Overview..............................................................................................................................2

26.1. The binomial pricing model.......................................................................................6

26.2. What can you learn from the binomial model?........................................................11

26.3. Multi-period binomial model...................................................................................14

26.4. Advanced topic: Using the binomial model to price an American put...................19

Conclusion .........................................................................................................................24

Exercises ............................................................................................................................25

This is a preliminary draft of a chapter of Principles of Finance with Excel. 2001 2005 Simon Benninga

(benninga@wharton.upenn.edu ).

page 1

Overview

In Chapter 25 we discussed the Black-Scholes formula, the most common method for

pricing options. In this chapter we discuss the other major technique for determining option

prices, the binomial option pricing model. This model gives some insights into how to price an

option, and its also used widely (though not as widely as the Black-Scholes equation).

The basis of the binomial model is a very simple description of stock price uncertainty.

Heres an example: Suppose the current stock price of MicroDigits (MD) is $100. What can

you say about the MD stock price one year from now? The binomial model assumes that the

price of the stock in one year will either go up by a certain percentage or down by a certain

percentage. Heres an example:

A

(MD) STOCK PRICE

1

2 Up

3 Down

4

5 MD stock

6

7

8

9

10

11

12

13

14

15

16

30%

-10%

130

<-- =100*(1+B2)

90

<-- =A7*(1+B3)

100

Date 0

today

Date 1

one year

from now

0.3

Date 0

today

<-- =C6/A7-1

-0.1

<-- =C8/A7-1

Date 1

one year

from now

page 2

In the example above the MD stock price will either go up by 30% or down by 10% one

year from today. This means that the return on the stock will be either 30% or -10% (cells C13

and C15).

It is difficult to believe that such a simple description of stock price uncertainty could be

useful. However, if we extend the model to more periods, it turns out that the binomial model

can describe a wide range of stock price behaviors. In the example below we assume that the

price of MD stock goes up in each of the next two years by 30% or goes down by 10%. This

means that there are three possible outcomes for the stock price at Date 2: It can be either $169,

$117, or $81.

A

STOCK PRICE

1

2 Up

3 Down

4

5

6

7

8

9

10

30%

-10%

169

<-- =C6*(1+B2)

117

<-- =C6*(1+B3)

81

Date 2

two years

from now

<-- =C8*(1+B3)

130

100

90

Date 0

today

Date 1

one year

from now

If we extend the model to more periods, well get a wide range of possible prices and

returns. In the spreadsheet below we look at stock prices after 10 periods:

page 3

1

2 Up

3 Down

4

5 Date

0

6

7

8

9

10

11

12

13

14

15

16

17

100.00

18

19

20

21

22

23

24

25

26

27

30%

-10%

10

1378.58

1060.45

815.73

627.49

482.68

371.29

285.61

219.70

169.00

130.00

117.00

117.00

334.16

197.73

152.10

81.00

270.67

160.16

94.77

187.39

110.88

65.61

219.24

168.65

129.73

99.79

76.76

59.05

316.69

243.61

144.15

85.29

457.44

351.87

208.21

123.20

72.90

390.97

231.34

136.89

660.74

508.26

300.75

177.96

105.30

564.74

434.41

257.05

954.40

734.16

151.78

116.76

89.81

69.09

53.14

105.08

80.83

62.18

47.83

72.75

55.96

43.05

50.36

38.74

34.87

If you plot the stock return and the probabilities of the returns after 10 years, you get a

graph such as the one below.1

The mathematics required to produce such a graph are too much for this book. For further details see my book

page 4

0.25

0.2

"down" return is -10%, then after 10 periods, the

probability of a return of 357% is 11.72%.

Probability

0.15

0.1

0.05

0

-100%

0%

100%

200%

300%

400%

500%

600%

700%

800%

900%

1000%

1100%

1200%

1300%

Return

A pedagogical note

Most finance books first discuss the binomial option model and then discuss BlackScholes. Their reasoning is that this order is logical because in principle the Black-Scholes

pricing formula can be derived from the binomial model. In this book weve reversed the order,

because we despair of telling you exactly how Black-Scholes is derived from the binomial.

Instead, weve treated the two models as entirely different topics with different pedagogical

goals: Black-Scholes is the most commonly used option pricing model; as a finance person you

should be familiar with this model and understand how to manipulate it (notice that we havent

said that you need to understand it!). The binomial model is more educational but less useful (at

least on the level of this book): It gives some insights into how options are priced through a

page 5

process of replication. It can also be used to understand topics such as the pricing of American

options and real options.

One of the uses we show for the binomial option pricing model is the use of the model to

price American options (section 26.4). These options cannot be priced using the Black-Scholes

formula, which prices only European options. In an advanced options course you will learn to

use the binomial option pricing model to price other, more complicated options.

Binomial model

Replicating portfolio

Max

To illustrate the use of the binomial model, we start with the following very simple

example:

Youre trying to calculate the value of a call option on ABC stock. The option

expires in one year and has an exercise price of $110.

page 6

ABC stock sells today for $100. A wise person has informed you that in one year, the

price of the stock will either be $130 or $90.2 We will refer to these possibilities as

the up and the down states.

The one-year interest rate is 6%. You can borrow or lend at this rate.

Heres a spreadsheet picture which incorporates all this information (the spreadsheet also shows

the payoffs on a put written on ABC stockwell get to that in a moment):

A

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

Up

Down

30%

-10%

Interest rate

Exercise price

100

6%

110

in the "up" state

Bond price

130

<-- =$B$11*(1+B2)

100

1.06

<-- =$G$12*(1+$B$7)

1.06

<-- =$G$12*(1+$B$7)

1

90

in the "down" state

<-- =$B$11*(1+B3)

Call payoff in

the "up" state

20

<-- =MAX(D10-$B$7,0)

???

<-- =MAX($B$7-D10,0)

20

<-- =MAX($B$7-D12,0)

???

0

<-- =MAX(D12-$B$7,0)

Call payoff in the

"down" state

Were going to price the call option by showing that there is a combination of the bonds

and stocks which gives exactly the same payoffs as the call option. To show this, we use some

basic high school algebra: Suppose we buy a portfolio of A shares of the stock and buy B bonds.

Then the payoff of the portfolio in the up state is 130 A + 1.06 B and the payoff of the portfolio

in the down state is 90 A + 1.06 B . Now lets find A and B so that these two payoffs equal the

call option payoffs:

This wise person forgot to tell you the probabilities attached to these 2 events, but it turns out not to matter.

page 7

130 A + 1.06 B = 20

90 A + 1.06 B = 0

130 A + 1.06 B = 20

90 A + 1.06 B = 0

20 0

0 90 A 90*0.5

A=

= 0.5, B =

=

= 42.4528

130 90

1.06

1.06

So now we know that buying half a share of ABC (cost: $50) and borrowing $42.4528

will give you payoffs in one year which are exactly the same as the payoffs of the call option.

The expenditure on this portfolio of {buy share, borrow $42.4528} should be the same as the

expenditure on the call option. Thus the call options price should be $7.5472:

call option price = 0.5*$100

.

$42.4528

= 7.5472

stock in the

"replicating

portfolio"

the financing

provided by

borrowing in the

"replicating

portfolio"

of the call

option

The portfolio we derived aboveA = 0.5 shares and B = -$42.4528 borrowedgives the

same payoffs as the call option. For this reason it is often called the replicating portfolio.

Option pricing in the binomial model is a wonderful example of the first two principles of

efficient markets discussed in Chapter 17. The first principle (Competitive markets have a

single price for a single good) implies that the combination of the stock + borrowing (which in

terms of payoffs has exactly the payoffs of the call option) should be priced like the call option.

The second principle, price additivity (The price of a bundle of securities should be the sum of

page 8

the prices of each of the securities) is also illustrated herethe price of the call option is the

cost of the stock ($45) minus the borrowing to finance this cost.

For option pricing theorists this method of pricing options is an example of arbitrage

the principle that if you can construct an assets payoffs in two ways, each of these ways should

have the same market value (which is, of course, Chapter 17s first principle of efficiency).

Summing it all up:

A

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

Up

Down

Initial stock price

Interest rate

Exercise price

30%

-10%

100

6%

110

in the "up" state

Bond price

130

<-- =$B$11*(1+B2)

100

1.06

<-- =$G$12*(1+$B$7)

1.06

<-- =$G$12*(1+$B$7)

1

90

in the "down" state

<-- =$B$11*(1+B3)

Call payoff in

the "up" state

20

<-- =MAX(D10-$B$7,0)

???

<-- =MAX($B$7-D10,0)

20

<-- =MAX($B$7-D12,0)

???

0

<-- =MAX(D12-$B$7,0)

Call payoff in the

"down" state

Stock, A

0.5000 <-- =(D17-D19)/(D10-D12)

Bonds, B

-42.4528 <-- =(D19-D12*B24)/(1+B6)

Call price

7.5472 <-- =B24*B5+B25

We now use the binomial model to price a put on ABC with an exercise price of 110.

The put payoffs are shown above:

page 9

G

H

14

15

16 Put option payoffs

17

18

???

19

20

21

22

J

Put payoff in the

"up" state

<-- =MAX($B$7-D10,0)

20

<-- =MAX($B$7-D12,0)

Put payoff in the

"down" state

130 A + 1.06 B = 0

90 A + 1.06 B = 20

A=

20

130 A 130 * ( 0.5)

= 0.5, B =

=

= 61.3208

130 90

1.06

1.06

The solution to the replicating portfolio indicates that short selling A = -0.5 shares and

investing in B = $61.3208 bonds gives the same payoffs as the put option. This means that the

price of the put is $11.3208:

put option price =

0.5*$100

+ $61.3208

= 11.3208

cash provided by

the short sale of

stock in the

"replicating

portfolio"

bonds in the

"replicating

portfolio"

of the put

option

Put price + Stock price = Call price + PV ( Exercise price )

page 10

= 7.5472 +

110

100 = 11.3208

1.06

A

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

31

32

33

34

35

36

37

Up

Down

Initial stock price

Interest rate

Exercise price

30%

-10%

100

6%

110

in the "up" state

Bond price

130

<-- =$B$11*(1+B2)

100

1.06

<-- =$G$12*(1+$B$7)

1.06

<-- =$G$12*(1+$B$7)

1

90

<-- =$B$11*(1+B3)

in the "down" state

Call option payoffs

"up" state

20

<-- =MAX(D10-$B$7,0)

???

<-- =MAX($B$7-D10,0)

20

<-- =MAX($B$7-D12,0)

???

0

<-- =MAX(D12-$B$7,0)

"down" state

The call replicating portfolio

Stock, A

0.5000 <-- =(D17-D19)/(D10-D12)

Bonds, B

-42.4528 <-- =(D19-D12*B24)/(1+B6)

Call price

7.5472 <-- =B24*B5+B25

The put replicating portfolio

Stock, A

-0.5000 <-- =(I17-I19)/(D10-D12)

Bonds, B

61.3208 <-- =(I17-D10*B29)/(1+B6)

Call price

11.3208 <-- =B29*B11+B30

Pricing the put by put-call parity

Call price

7.5472 <-- =B26

PV(exercise)

103.7736 <-- =B7/(1+B6)

Stock price

100 <-- =B5

Put price

11.3208 <-- =B34+B35-B36

The binomial option pricing model is very instructive. It is an easy way to price options,

and it can also tell you something about more complicated option pricing model. Here are a few

lessons you can learn from the binomial model.

page 11

A call looks like a portfolio composed of the purchase of a stock and the short sale of a

bond. The calls replicating portfolio is

A * SUp + B * (1 + r ) = Call payoffUp

A * S Down + B * (1 + r ) = Call payoff Down

where:

SUp and S Down are the stock prices in the "up" and "down" states

Call payoffUp and Call payoff Down are the call payoffs

In terms of the calls replicating portfolio, it turns out that A (the stock) is always positive

and B (the bond) is always negative. This indicates the purchase of a stock financed by

borrowing. In a sense the Black-Scholes formula has the same property:

BS call price = S * N ( d1 ) Xe rT N ( d 2 )

Purchase of

stock

(positive number)

Borrowing at

the risk free rate

( negative number )

A put looks like a portfolio composed of the short sale of a stock and the purchase of a

bond. The puts replicating portfolio is:

A * SUp + B * (1 + r ) = Put payoffUp

A * S Down + B * (1 + r ) = Put payoff Down

where:

SUp and S Down are the stock prices in the "up" and "down" states

Put payoffUp and Put payoff Down are the put payoffs

In terms of the puts replicating portfolio, it turns out that A (the stock) is always negative

and B (the bond) is always positive. This indicates the purchase of bonds financed by a

short sale of the stock. In a sense the Black-Scholes formula has the same property:

BS put price = S * N ( d1 ) + Xe rT N ( d 2 )

Short sale of

stock

(negative number)

Investing at

the risk free rate

( positive number )

page 12

The probabilities of the up and the down states dont appear explicitly in the calculation

of the option price. To see what this means, look at the way we solved for the call option

price at the beginning of this chapter:

130 A + 1.06 B = 20

90 A + 1.06 B = 0

These equations solve to give:

20 0

0 90 A 90*0.5

A=

= 0.5, B =

=

= 42.4528

130 90

1.06

1.06

The resulting call option price:

call option price = 0.5*$100

$42.4528

= 7.5472

stock in the

"replicating

portfolio"

the financing

provided by

borrowing in the

"replicating

portfolio"

of the call

option

This calculation of the call option price when the option exercise price is $110 relies on 3

facts: i) The current stock price is $100, ii) The stock price next period is either 130 or

90, iii) The interest rate is 6%. Nowhere in this calculation have we made any reference

to the probabilities that the stock price will be $130 or $90.3

The binomial model is extendibleit can be used to price many options in a multiperiod

setting. In the next section we show a multi-period binomial model.

Of course you could quibble a bit and insist that the stock price today must incorporate these probabilities in some

sense, and youd be right. But even here you have to be carefulfor example, it would be wrong to say that the

stock price is the discounted expected future payoff of the stock. To explain this all would take us too far afield

suffice it to say that if investors are risk averse, theyll price the stock at below its expected future discounted

payoff. The amount of this discount depends on the risk aversion.

page 13

The binomial model can be extended to multiple periods. Heres an example which

extends the previous example:

A

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

Up

Down

30%

-10%

Interest rate

Exercise price

100

6%

110

Stock price

Bond price

169.00

1.1236

130

100

1.06

117.00

90

Date 0

Date 1

1.1236

1.06

81.00

Date 2

Date 0

Date 1

1.1236

Date 2

59.00

<-- =MAX(E10-$B$7,0)

0.00

???-1

???-0

7.00

<-- =MAX(E12-$B$7,0)

0.00

Date 2

<-- =MAX(E14-$B$7,0)

???-0

???-2

Date 0

Date 1

<-- =MAX($B$7-E10,0)

???-1

0.00

<-- =MAX($B$7-E12,0)

29.00

Date 2

<-- =MAX($B$7-E14,0)

???-2

Date 0

Date 1

In this example, the stock price goes up by 30% or down by 10% in each period. Starting

with a stock price of $100 at Date 0, the stock price at Date 1 will be either $130 or $90, and the

stock price at Date 2 will be either $169, $117, or $81.

$169: This happens if it goes up twicethat is: 169 = 100* (1.30 )(1.30 )

$117: This happens if the stock price goes up once and down oncethat is:

117 = 100* (1.30 ) * ( 0.90 ) . Notice that it doesnt matter if the stock price goes up first

$81:

This happens if the stock price goes down twicethat is 81 = 100* ( 0.90 )( 0.90 ) .

In each period the risk-free interest rate is 6%, so that $1 invested in the bond will grow to

$1.1236 at date 2.

page 14

At the end of the second period, the options payoffs are given by

Max (169 110,0 ) = 59

Max ( 81 110,0 ) = 0

We now have to value the option. We proceed by doing 3 valuationsthese are labeled in the

diagram as ???-1, ???-2, and ???-0. The put option has the same labelswell figure out

in a while how to price these.

We proceed as we did for the one-period binomial option pricing model. Setting up the

one-period stock and bond prices and option payoffs, we get:

26

27

28

29

30

31

32

33

34

35

36

37

38

39

40

41

A

B

Finding ???-1 for the call

Stock price

Bond price

169.00

130

1.1236

1.06

117.00

1.1236

59.00

???-1

7.00

The call replicating portfolio

Stock, A

1.0000 <-- =(D34-D36)/(D29-D31)

Bonds, B

-97.8996 <-- =(D36-B39*D31)/H29

Call price

26.2264 <-- =B39*B30+B40*F30

Setting up the equations (we use A to denote the number of shares and B to denote the bonds in

the replicating portfolio):

page 15

169 A + 1.1236 B = 59

117 A + 1.1236 B = 7

Solution:

59-7

=1

169-117

7 117 * A

B=

= 97.8996

1.1236

A=

Again we proceed as we did for the one-period binomial option pricing model. Setting

up the one-period stock and bond prices and option payoffs, we get:

44

45

46

47

48

49

50

51

52

53

54

55

56

57

58

59

A

B

Finding ???-2 for the call

Stock price

Bond price

117.00

90

1.1236

1.06

81.00

1.1236

7.00

???-2

0.00

The call replicating portfolio

Stock, A

0.1944 <-- =(D52-D54)/(D47-D49)

Bonds, B

-14.0174 <-- =(D54-B57*D49)/H47

Call price

2.6415 <-- =B57*B48+B58*F48

Once more we set up a simple binomial model, but this time we use the two values

derived abovethe prices of the call option at date 1.

page 16

62

63

64

65

66

67

68

69

70

71

72

73

74

75

76

77

A

B

Finding ???-0 for the call

Stock price

Bond price

130.00

1.0600

100

1

90.00

1.0600

26.2264

???-0

2.6415

The call replicating portfolio

Stock, A

0.5896 <-- =(D70-D72)/(D65-D67)

Bonds, B

-47.5703 <-- =(D72-B75*D67)/H65

Call price

11.3919 <-- =B75*B66+B76*F66

As you can see from the diagram, the put has date 2 payoffs of:

G

H

18 Put option price

19

20

21

???-0

22

23

24 Date 0

0.00

<-- =MAX($B$7-E10,0)

0.00

<-- =MAX($B$7-E12,0)

29.00

Date 2

<-- =MAX($B$7-E14,0)

???-1

???-2

Date 1

We can use the same logic (and even the same equations) to price the put. The results,

shown below with no explanations) show that the put price at date 0 is 9.2916.

You probably suspect that theres a more efficient way to do this, and youre right. A good starting place is

page 17

A

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

98

99

100

101

102

103

104

105

106

107

108

109

110

111

112

113

114

115

116

117

118

119

120

121

122

123

124

125

126

127

128

129

130

131

132

Finding ???-1 for the put

Stock price

Bond price

169.00

130

1.1236

1.06

117.00

1.1236

0.00

???-1

0.00

The put replicating portfolio

Stock, A

0.0000 <-- =(D89-D91)/(D84-D86)

Bonds, B

0.0000 <-- =(D91-B94*D86)/H84

Put price

0.0000 <-- =B94*B85+B95*F85

calculations for ???-1: The price

???-1 is the value of a security

which has zero payoffs one period

hence. By any logic this price

should be zero.

Stock price

Bond price

117.00

90

1.1236

1.06

81.00

1.1236

0.00

???-2

29.00

The put replicating portfolio

Stock, A

-0.8056 <-- =(D107-D109)/(D102-D104)

Bonds, B

83.8822 <-- =(D109-B112*D104)/H102

Put price

16.4151 <-- =B112*B103+B113*F103

Stock price

Bond price

130.00

100

1.0600

1

90.00

1.0600

0.0000

???-0

16.4151

The put replicating portfolio

Stock, A

-0.4104 <-- =(D125-D127)/(D120-D122)

Bonds, B

50.3293 <-- =(D127-B130*D122)/H120

Put price

9.2916 <-- =B130*B121+B131*F121

page 18

We can also use put-call parity to price the put. As discussed in Section 24.3 put-call

parity says:

Put price + Stock price = Call price + PV ( Exercise price )

= 11.3919 +

135

136

137

138

139

140

110

(1.06 )

100 = 9.2916

A

B

C

D

E

Pricing the put with put-call parity

Initial stock price

100

Interest rate

6%

Exercise price

110

Call price

11.3919

Put price

9.2916 <-- =B139+B138/(1+B137)^2-B136

26.4. Advanced topic: Using the binomial model to price an American put

The binomial model is cute and easy to understand. But why do we need it? The answer

is complex and mostly beyond the scope of this book:

Whereas the Black-Scholes formula prices only European options, the binomial model

can be used to price American options. This use of the binomial model is illustrated in

the next sub-section.

Properly implemented, the binomial model can help us prove the Black-Scholes formula.

This use of the binomial model is too advanced for this book.

page 19

The binomial model can be used to price more complex options than those priced with

Black-Scholes, which prices only European options.

binomial model to price options where the exercise price changes over time, or where the

interest rate varies.

We can also use the binomial model to price options where the up and the down

movements of the stock price vary over time. Many finance people believe, for example,

that the volatility of the stock price return varies with the price itselfthat the percentage

up and the down movements for a stock are larger when the stock price is small.

This can be handled by the binomial model, but not by Black-Scholes.

page 20

The binomial model is especially useful in determining the price of weird options.

Here are two examples of such options.

An Asian option is an option whose payoff is determined by the average price of the

stock over a certain period before the options maturity. One specification of an Asian call

option might be:

On 29 January 2005 you buy an Asian call option on IBM with a maturity of one year.

The options payoff on 29 January 2006 is the difference between the average daily

closing IBM stock price in the 30 days preceding the options maturity and the options

exercise price X = $120. This option cannot be priced using the Black-Scholes model,

but it can be priced using the binomial model.

A barrier option is an option whose payoff depends on whether the stock price reaches a

On 29 January 2005 you buy a one-year knock-in barrier option on IBM, which is

currently selling at $93. The option specifies that you have the right to buy a share of

IBM on 29 January 2006, provided that at some point during the year IBMs stock price

exceeds $120 (this is the knock-in barrier. If the price of IBM during the coming year

does not exceed $120, your option is worthless. Barrier options cannot be priced using

the Black-Scholes model, but they can be priced using the binomial model.

There are many more of these weird options.

background is http://www.riskglossary.com .

page 21

To illustrate one more-sophisticated use of the binomial model, well show you how it

can be used to price an American option. Recall that American options can be exercised early.

We go back to our 2-date example and focus on the put price (highlighted):

A

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

Up

Down

30%

-10%

Interest rate

Exercise price

100

6%

110

Stock price

Bond price

169.00

1.1236

130

1.06

100

117.00

1.1236

90

1.06

81.00

1.1236

59.00

<-- =MAX(E10-$B$7,0)

???-1

0.00

<-- =MAX($B$7-E10,0)

0.00

<-- =MAX($B$7-E12,0)

29.00

<-- =MAX($B$7-E14,0)

???-1

???-0

7.00

<-- =MAX(E12-$B$7,0)

???-0

???-2

???-2

0.00

<-- =MAX(E14-$B$7,0)

Well price the put just as we did the call in the previous section. However, this time we

assume that the put is an American putmeaning that it can be exercised early.

We start by pricing the put at the up-state of date 1 (this is marked ???-1 in the

spreadsheet. This is actually fairly simple: at ???-1 the put owner has future payoffs of zero, no

matter what happens. This means that the put should be worth zero, and thats exactly what the

spreadsheet tells us:

24

25

26

27

28

29

30

31

32

33

34

35

36

37

38

39

A

Finding ???-1 for the put

Stock price

Bond price

169.00

130

1.1236

1.06

117.00

Put option price

0.00

???-1

0.00

The put replicating portfolio

Stock, A

Bonds, B

Put price ???-1

1.1236

There's actually no need to do

any calculations for ???-1: The

price ???-1 is the value of a

security which has zero payoffs

one period hence. By any logic

this price should be zero.

0.0000 <-- =(D34-B37*D29)/H27

0.0000 <-- =B37*B28+B38*F28

page 22

At ???-2 the situation is more complicated. The put has a future payoff which is positive.

We can use the binomial model to solve for the put price:

42

43

44

45

46

47

48

49

50

51

52

53

54

55

56

57

58

A

Finding ???-2 for the put

Stock price

Bond price

117.00

1.1236

90

1.06

81.00

1.1236

0.00

???-2

29.00

The put replicating portfolio

Stock, A

Bonds, B

European put price ???-2

American put price ???-2

-0.8056

83.8822

16.4151

20.0000

<-- =(D50-D52)/(D45-D47)

<-- =(D52-B55*D47)/H45

<-- =B55*B46+B56*F46

<-- =MAX(B7-B46,B55*B46+B56*F46)

But now the early-exercise feature of the put comes in (rememberits an American

put). The put value of $16.4151 (cell B57 above) is the value of a put which has payoffs only

next period. Instead of waiting until next period, we can exercise the put today: The stock price

is $90 and the put exercise is $110, which means we can collect $20 immediately if we earlyexercise the put. So the actual put valuegiven the early-exercise featureis $20 and not

$16.4151 (cell B58):

Using this value of $20, we can price the put at date 0:

60

61

62

63

64

65

66

67

68

69

70

71

72

73

74

75

A

Finding ???-0

Stock price

Bond price

130.00

100

1.0600

1

90.00

1.0600

0.0000

???-0

20.0000

The put replicating portfolio

Stock, A

-0.5000 <-- =(D68-D70)/(D63-D65)

Bonds, B

61.3208 <-- =(D70-B73*D65)/H63

American put price ???-0

11.3208 <-- =MAX(B7-B64,B73*B64+B74*F64)

page 23

In Section 26.3 we priced a European put with the same exercise price X = $110. There

we concluded (page000) that the value of the European put is $9.2916. When we reprice the put

as an American put, we see that its price is $11.3208, higher than the European put price. This

happens because we will want to early-exercise the put at ???-2.

Conclusion

The binomial option pricing model can be used to price options under more general

conditions than those which hold for the Black-Scholes model. This chapter has revealed only

the tip of this financial iceberg, showing you how to implement the model in a 1-date and 2-date

framework. Weve also indicated how the model can be used to price American options and

weird options such as Asian options or barrier options.

page 24

Exercises

1. A stock selling for $25 today will, in one year, be worth either $35 or $20. If the interest rate

is 8%, what is the value today of a one-year call option on the stock with exercise price $30?

Use the simultaneous equation approach of section 14.1 to price the option.

2. In the exercise 1: Calculate the value today of a one-year put option on the stock with

exercise price $30. Show that put-call parity holds: That is, using your answer from this

problem and the previous problem, show that:

call price +

X

= stock price today + put price

1+ r

3. In a binomial model a put option is written on a stock selling today for $30. The exercise

price of the put option is 40. The put options payoffs are 20 and 5. The price of the put is

12.25. What is the riskless interest rate? Assume that the basic period is one year.

4. All reliable analysts agree that a share of ABC Corp., selling today for $50, will be priced at

either $65 or $45 one year from now. They further agree that the probabilities of these events

are 0.6 and 0.4 respectively. The market risk-free rate is 6%. What is the value of a call option

on ABC whose exercise price is $50 and which matures in one year?

5. A stock is currently selling for 60. The price of the stock at the end of the year is expected

either to increase by 25% or to decrease by 20%. The riskless interest rate is 5%. Calculate the

page 25

price of a European put on the stock with exercise price 55. Use the binomial option pricing

model.

THREE DATE BINOMIAL OPTION PRICING

Up

Down

35%

-5%

Interest rate

Exercise price

40

25%

40

state prices

qu

???

qd

???

Stock price

Bond price

???

???

???

40

???

???

???

???

???

???

???

???

???

???

???

???

???

???

???

???

???

???

???

???

???

???

???

???

???

7. Consider the following 2-period binomial model, in which the annual interest rate is 9% and

in which the stock price goes up by 15% per period or down by 10%:

Stock price

Bond price

66.1250

1.1881

57.50

50

1.09

51.7500

45.00

1.1881

1.09

40.5000

1.1881

page 26

c. Price an American call on the stock with exercise price 60.

d. Price an American put on the stock with exercise price 60.

In each period the stock price either goes up by 30% or decreases by 10%.

Stock price

Bond price

50.70

1.5625

39.00

30

1.25

35.10

1.5625

27.00

1.25

24.30

1.5625

a. Consider a European call with X = 30 and T = 2. Fill in the blanks in the tree:

Call option price

???

???

???

???

???

???

c. Now consider an American put with X = 30 and T = 2. Fill in the blanks in the tree:

American put option price

???

???

???

???

???

???

9. A prominent securities firm recently introduced a new financial product. This product, called

The Best of Both Worlds (BOBOW for short), costs $10. It matures in 5 years, at which point

page 27

it repays the investor the $10 cost plus 120% of any positive return in the S&P500 index. There

are no payments before maturity.

For example: If the S&P500 is currently at 1500, and if it is at 1800 in 5 years, a

BOBOW owner will receive back $12.40 = $10*[1 + 1.2*(1800/1500-1)]. If the S&P is at or

below 1500 in 5 years, the BOBOW owner will receive back $10.

Suppose that the annual interest rate on a 5 year, continuously compounded, purediscount bond is 6%. Suppose further that The S&P500 is currently at 1500 and that you believe

that in 5 years it will be at either 2500 or 1200. Use the binomial option pricing model to show

that BOBOWs are worth more than their current price of $10.

10. A call option is written on a stock whose current price is $50. The option has maturity of 2

years, and during this time the annual stock price is expected to increase by 25% or to decrease

by 10%. The annual interest rate is constant at 6%. The option is exercisable at date 1 at a

price of $55 and at date 2 for a price of $60. What is its value today? Will you ever exercise the

option early?

11. A stock is currently selling for 60. A Put option has maturity of 2 years, and during this

time the annual stock price is expected to increase by 30% or to decrease by 10%. The riskless

interest annual rate is 6%. The put option is currently selling for $9. Is the option more likely an

American or a European put option? Use the binomial option pricing model to determine.

12. A call option is written on a stock whose current price is $100. The option has maturity of 2

years, and during this time the annual stock price is expected to increase by 30% or to decrease

page 28

by 10%. The annual interest rate is constant at 6%. The options exercise price is $110. Extend

the Binomial Option Pricing to incorporate a $3.00/share dividend that will be paid out in

period 2. In other words, all of the period 2 stock prices will be reduced by $3.00. Determine the

current prices of the call. Compare to the non-dividend case that is appears in Chapter 26.

13. A 2-years American put option is written on a stock whose current price is 42. You expect

that in each year the stock price either goes up by 10% or decreases by 5%. The one-period

interest rate is 5%. The options exercise price is 45.

Will you ever exercise the option early? Refer to Fact 6 of Chapter 21.

page 29

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