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BINOMIAL OPTION PRICING

MODEL
Done By:
Dheepa Ravi
Mohana Priya. V
INTRODUCTION
Futures and Forwards are fairly easy to value,
because the fact that a future/ forward contract
imposes an obligation on both the parties to the
agreement.

Options however are relatively more complex.
This is because one party has a right while the
other party has an obligation. Thus, as far as the
holder of the option is concerned, he may or may
not choose to exercise his right.

INTRODUCTION
In the case of European options, the decision
to exercise would depend
Whether S
t
> X in the case of calls, or
Whether S
t
< X in the case of puts.

Consequently we are concerned with the odds
of exercise and the expected payoff at
expiration.
INTRODUCTION
For American options the issue is even more
complex, for the holder has the right to
exercise at any point in time.
Consequently for options, it matters not only
as to where the stock price is currently, but
also as to how it is expected to evolve.
Hence in order to value an option, we have to
postulate a process for the price of the
underlying asset.

Binomial Option Pricing Model(BOPM)
The binomial model was first proposed
by Cox, Ross and Rubinstein (1979).
An option pricing model in which the
underlying asset can assume one of only two
possible, discrete values in the next time period
for each value that it can take on in the
preceding time period.
This model assumes that given a value for the
stock price, at the end of the next period, the
price can either be up by X% or down by Y%.

Assumptions of BOPM

The assumptions underlying the model are the following:
1. There are no frictions in the market such as transaction costs or
taxes.
2. Securities are infinitely divisible, that is investors can trade in
fractions of securities.
3. There are two possible prices for the underlying asset on the
next date. The underlying price will either be:
- Increase by a factor of u%
- Decrease by a factor of d%
4. The uncertainty is that we do not know which of the 2 prices
will be realised.
5. The one-period interest rate, r, is constant over the life of the
option (r% per period).







The Concept of Riskless Hedge
Purpose: : To determine the value of an option.
Motivation:
Hedge portfolio: Hedger buys shares of stock and
simultaneously writes a call option to hedge the stock.
Hedger receives premium from sale of call and is
obligated to deliver stock if option buyer exercises the
option.
If stock goes up , hedger gains on stock but loses on
option.
If stock comes down, hedger loses on stock but gains on
option.
The loss and gain therefore offset each other.




Hedge Portfolio
It is possible to create a hedge portfolio (of
stock + calls) such that the hedger ends up
with a riskless position
in that the value of the portfolio when the
stock goes up is the same as when the stock
goes down.

If portfolio is riskless, then its return should be
equal to the riskfree rate (r
F
), in equilibrium

One Period Model
Stock price(S
0
) = 20
U = (1.1) = 22
D = (0.9) = 18
Buy European call option = 21
Risk free rate of interest (r) = 0.12
T ( 3 months) i.e 3/12 = 0.25


Long Shares of the stock
Short 1 Call Option
Generalization
Stock price = S
0

Option price = f
Time = T
Price move up = S
0
u, Payoff = f
u

Price down to = S
0
d, Payoff = f
d




Long Position in shares
Short Position in 1 option

If there is a up movement of stock price, the value is S
0
u - f
u



If there is a down movement of stock price, the value is S
0
d - f
d


The two are equal when S
0
u - f
u
= S
0
d - f
d


Or


The present value of portfolio is

The cost of setting up the portfolio is

It follows that


OR

Where f is the value of the call option
Two Period Model