Académique Documents
Professionnel Documents
Culture Documents
A Three Step Process: 1) Construct a Stock Price Binomial Tree 2) Value the Option at Time of Expiry 3) Value the Option Through Backward Induction
Because d is the reciprocal of u, u*d = 1. Therefore, if S0 takes an up move followed by a down move or vice versa, the price will return to S0. We will use these formulas for u and d to model a Stock Price Binomial Tree.
Transition Probabilities
If the probability of S0 rising to Su is p, then the probability of S0 falling to Sd must be 1-p, since one of those two outcomes must happen in this model. We can say that the expected price at t1 is the probability of the up move happening times the up price plus the probability of the down move happening times the down price.
We want the Binomial Method to be risk neutral. A riskless asset should grow by a factor of after delta t, with r as the riskless interest rate. Set the risk neutral expected value of S equal to the binomial expected value of S.
This is the risk-neutral transition probability of an up move. Remember that u and d only depend on the volatility and the length of the time interval, so this probability only depends on volatility, the length of a time interval, and the riskless interest rate. All of these will remain constant throughout our binomial tree, so this probability will remain constant throughout the tree as well.
While we dont know the value of the option before time of expiry, we do know the value of the option at the time of expiry: its simply the payoff of the option. For our example, the value of the European call at T is ST K if ST > K and 0 otherwise. We will construct a second binomial tree identical in structure to our Stock Price Tree, which will serve as our Option Value Tree. We can fill in the nodes at t4 = T.
We want to choose delta and B such that the value of the portfolio is equivalent to the value of an option on that stock, depending on the direction the stock goes. Were replicating the payout of the option with our portfolio, so we want:
The portfolio, with these values of delta and B, replicates the value of the option V on stock S. So at t0:
We finally have a way to find the value of option at earlier nodes. We know S0, the riskless interest rate, the length of the time interval, and the value of the option at later nodes (specifically at T). Further manipulation brings the riskless probability into play:
Observe: each sub-piece of the Binomial Tree is its own one-period tree
= e-.05(.25)(.5043*82.21+(1 - .5043)*34.99) = $58.07 Now we can fill in that node on our option value tree.
We continue the process by filling in the rest of the nodes at t3. Once weve done that, the nodes at t3 become the the Vus and Vds for the V0s at t2. We continue working backwards until we have a value for the option at t0, the actual V0, which is the price of the option and what weve been looking for. The rest of the option value tree fills in like this:
Compare to Black-Scholes
The Binomial Tree Method gave us a price of $13.53 on that European call option. The Black Scholes PDE gave that same option a price of $14.23. Why the discrepancy? Remember, this is a time-discrete approximation to the Black-Scholes method. We only used four time intervals and came within less than a dollar of the Black-Scholes method. Increasing the number of time intervals (and thus making each time interval shorter in length), would increase the methods accuracy because our model would then be a better approximation of the time continuous model.
Value at Node a = max ( =$0.84 Value at Node b = max ( = $12 Value at Node c = V0 = max ( = max(5.49, 2) = $5.49
Sources