CHAPTER

11
P 111

Understanding Binomial Tree

You are required to value a 12m option on an asset currently trading at Rs 100 using
4stage binomial tree. The risk free rate is 8% p.a. with quarterly compounding. The
stock can take only two values at the end of each quarter with either 10% up or 10%
down. Answer the following:
a) How many endvalues the asset can have?
b) Find out all the end values.
c) What is the probability of each end value?
Solution
a) For a 4 stage binomial tree the number of end values would be 4+1 = 5. With
addition of each stage in the binomial tree the end values increase by one.
b) The five end values would be formed by up and down movements as follows:
Initial value
100
up move
10%
Down move
10%
End Value
4
Rs 146.4
All the four are up moves
1.1 x 100
3
1
3 up moves and 1 down
119.7
1.1 x 0.9 x
2
2
move
998.0
100 x 0.9 x
2 up moves and 2 down
1.1
3
moves
1
100x 0.9 x
1
up move and 3 down
80.1
1.1
4
moves
9
100 x 100
All the four are down
65.6
0.9
moves
1
4
c) There would be total of 2 = 16 paths to reach
the end values
The number of paths leading to 5 different end
values are:
For
146.41
1
119.79
4
98.01
6
80.19
4
65.61
1

P 112

Risk Neutrality and Binomial Tree

Refer to Problem 111. Under risk neutral valuation with binomial tree what would be
the probabilities of up move and down move.
Solution
The probabilities of up and down moves depends upon a) the risk fee rate and b) the
size of up and down moves of the price of the underlying asset.
Risk free rate, r
=
2.00%
Up value, u
=
1.10
Down value, d
=
0.90
(1+ r) d
Prob of up
=
0.60
u
move =
d
Prob of down move =
=
0.40
End value
Down
Nos. of
Probability of end
Up moves
moves
paths
value
146.41
4
0
1
0.1296

119.79
0.3456
98.01
0.3456
80.19
0.1536
65.61
1

4
Total
1

0.0256

P 113

Option Value with Binomial Model

For the parameters of Problem 111 and 112 find the value the European call and
European put with 12 months to maturity and strike price of Rs 120.
Soluti
on
Strike of call
100
Risk free rate/period

100

Strike of put

0.02
Values in Rs
Put Option

Call Option
End
value
Payoff
Probability
146.41
0.1296
46.41
6.01
119.79
0.3456
19.79
98.01
0.3456
6.84
80.19
0.1536
0
65.61
0.0256
0.00
Value of option at end
Value of the option today

P 114

Payoff
0.00
0.00
0.00
0.00
1.99
0.69
12.85

4.61
4.26

11.88

Valuing European Put with Binomial

For the parameters of Problem 111 depict the 4stage binomial tree for a put option with
strike price of Rs
120.
Soluti
on

Up value
1.1
value
0.9
Prob up move
0.6
down move
0.4
Exercise Price
120
rate
per period The 4stage binomial tree is as follows
The value of put at each node is shown in
red italics

110.00
108.90
8.45
8.75
99.00
98.01
14.02

16.34
21.99
90.00
89.10
23.08

Prob
Risk free
2% X

146.4
1
0.0
0

133.10
0.08
121.00
119.79
3.48
0.21

100.00

Down

28.55
81.00
80.19
34.34
39.81
72.9
0
44.7
5
65.61
54.39

P 115

Valuing American Put with Binomial Tree

What would be the value of the put in Problem 114 if it were an American option?
Solution
The binomial tree fro the American put is depicted below:
The nodes value are with red italic (for value derived from succeeding nodes) or blue
italics (where the put option value is upon exercise at the node)
146.4
1
0.0
133.10
0
0.08
121.00
119.79
4.40
0.21
110.00
108.90
10.82
11.10
100.00
99.00
98.01
18.13
21.00
21.99
90.00
89.10
30.00
30.90
81.00
80.19
39.00
39.81
72.9
0
47.1
0
65.61
54.39

P 116

Risk Neutrality and Binomial Tree

A stock is currently trading at Rs 50. Over a period of one month it can either go up by
10% or fall by 10%. Using single period binomial method what is the value of 1 m call
and 1 m put option with strike price of Rs
50? Assume European option and 12% risk free interest rate with monthly
compounding. Draw the binomial tree indicating the values of stock, call and put at
expiry. Further verify the put call parity using call price found earlier.
Solution
The binomial tree of the situation is depicted below:
Call X=
Put X = Stock
50
50
55
5
0
10%
S0 = 50
10%
45

0
5

Portfolio
Short 1 call and Long
Long 1 Put and Short
stock
stock
Value at maturity
= price of Rs
At
5
55 x 5
55 x + 0
5
At price of Rs
4
45 x 0
45 x + 5
Equating the two values gives
55 x 5
=
45 x 0
55 x + 0
=
45 x
+ 50.5

=
0.5

=
Therefore ending value of the portfolio
0.5 x 55 5
=
22.50
55 x 0.5 0
=
27.50
Value of the portfolio being certain at the end it cannot grow at rate more than
risk free rate. Therefore the cost of setting the portfolio at t = 0 must be equal to
the discounted value at maturity.
If c is the value of the call option then
then
(0.5 x 50 1 c) x (1+0.01) = 22.5
+ 1 p) x (1+0.01) = 27.5 gives c =
gives p =
2.23
Put call parity
p = c + X/(1+r) S
= 2.72 + 50/1.01 50
= 2.23
P 117

If p is the value of the call option

(0.5 x 50
2.72

Risk Neutral Valuation

Value the call and put options of Problem 116 by making a risk free portfolio.
Solution
Delta of call = 5/10 = 0.5
Therefore the risk free portfolio would be 0.5 stock and
1 short call. The endvalue of the portfolio is Rs 55 x
0.5 5 = Rs 22.50
Cost of setting the portfolio should be present value of the endvalue of portfolio
discounted at 1% per month. Hence
50 x 0.5 1 c = 22.50/1.01 we get c = Rs 2.72

Delta of put = 5/10 = 0.5

Therefore the risk free portfolio would be 0.5 stock
and 1 long put. The endvalue of the portfolio is Rs 55
x 0.5 0 = Rs 27.50
Cost of setting the portfolio should be present value of the endvalue of portfolio
discounted at 1% per month. Hence
50 x 0.5 + 1 p = 27.50/1.01 we get p = Rs 2.23