Part-21

The Binomial Option Pricing Model

 Recap of Futures Pricing

• Futures and forward contracts were fairly

easy to value.
• All that we had to do was to identify a
relationship that would preclude both cash
and carry as well as reverse cash and carry
arbitrage.
 Recap (Cont…)
• The ease of this result was due to the fact
that a futures/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.
 Recap (Cont…)

• Thus as far as the holder of the option is

concerned, he may or may not choose to
exercise his right.
• In the case of European options, the
decision to exercise would depend on
whether ST > X in the case of calls, or
whether ST < X in the case of puts.
 Recap (Cont…)

• Consequently we are concerned with the

odds of exercise and the expected payoff at
expiration.
• For American options the issue is even
more complex, for the holder has the right
to exercise at any point in time.
 Recap (Cont…)
• 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.
• The eventual pricing formula is a function
of the process that is assumed.
 Recap (Cont…)

• Some processes will lead to precise

mathematical solutions.
• These are called closed-form solutions.
• In other cases, all that we will get is a
partial differential equation, which has to be
solved by numerical approximation
techniques.
 The Binomial Model

• The first model that we will study is called

the Binomial Option Pricing Model
(BOPM).
• 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%.
 Binomial Model (Cont…)
• Since the stock price can take on only one
of two possible prices subsequently, the
name Binomial is used to describe the
process.
• We will first study the model using a single
time period.
• That is, we will assume that we are at time
T-1, and that the option will expire at T.
 The One Period Model

• Let the current stock price be S0.

• At the end of the period, the price ST can be
The One Period Model (Cont…)
 One Period (Cont…)

• Y in this case is obviously a negative

number.
• The stock price tree may be depicted as
follows.
The Stock Price Tree
 Binomial Model (Cont…)
• Now consider a European call option.
• We will denote the exercise price by E,
since X has already been used to denote an
up movement for the stock price.
• In the case of the Binomial model, we
always start with the expiration time of the
option, since the payoffs at expiration are
readily identifiable.
 Binomial (Cont…)

• We will then work backwards.

• Let us denote the call value if the upper
stock price is reached by Cu, and the call
value if the lower stock price is reached by
Cd.
• Cu = Max[0, uS0 – E]
• Cd = Max[0, dS0 – E]
 Binomial (Cont…)

• Our objective is to find that value of the call

option one period earlier, that is right now.
• We will denote this unknown value by C0.
 A Risk-less Portfolio
• In order to price the option, we will
consider the following investment strategy.
• Let us buy α shares of stock and write one
call option.
• The current value of this portfolio is:
∀ αS0 – C0.
• The negative sign in front of the option
value indicates a short position.
 Risk-less Portfolio (Cont…)

• In the up state, the portfolio will have a

value of: αuS0 – Cu
• In the down state, the portfolio will have a
value of: αdS0 – Cd
• Suppose we were to select α in such a way
that the value of this portfolio is the same in
both the up as well as the down state?
 Risk-less Portfolio (Cont…)

• Then this portfolio may be said to be risk-

less since there are only two possible states
of nature in the next period.
• So if: αuS0 – Cu = αdS0 – Cd
 Risk-less Portfolio (Cont…)

∀ α is known as the hedge ratio.

• Since the portfolio is risk-less it must earn
the risk-less rate of return.
• Let us define r as 1 + risk-less rate.
• If so:
∀ αuS0 – Cu = αdS0 – Cd = (αS0 – C0)r
 Risk-less Portfolio (Cont…)

• Substituting for α, we get:

 The Option Premium

• Let us denote (r-d)/(u-d) by p.

• Therefore, (u-r)/(u-d) = 1-p.
• We can then write C0 as:
 The Option Premium (Cont…)

• This is the one period binomial option

pricing formula.
• p is known as the Risk Neutral probability.
 Numerical Illustration

• Let the current stock price be 100 and the

exercise price of a call option be 100.
• Let there be a possibility of a 20% up move
in the next period and a 20% down move in
the next period.
• Let the risk-less rate be 5% per period.
• Therefore r = 1.05.
 Illustration (Cont…)

• p = (1.05 - .8)/(1.2-.8) = .625

• 1-p = .375
• Cu = Max[0, 120 – 100] = 20
• Cd = Max[0, 80 – 100] = 0
• C0 = .625x20 + .375x0
------------------------------------ = 11.9048
1.05
 The Two-Period Situation

• Now let us extend the model to a case

where there are two periods to expiration.
• That is, the option expires at T, whereas we
are standing at T-2.
• We will denote the current stock price by S0
• The stock price tree can be depicted as
follows.
 The Stock Price Tree
uuS0
uS0

S0 udS0

dS0 ddS0

T-2 T-1 T
 Two Periods (Cont…)

• Once again, we know the payoff from the

option at expiration.
• Let us go back one period, that is to time
• T-1.
• At this point in time the problem is
essentially a one-period problem, to which
we have a solution already.
 Two Periods (Cont…)
• Let us denote the option premia corresponding to
values of the stock at time T, as Cuu, Cud, and Cdd.
• If so, then:
 Two Periods (Cont…)

• Knowing Cu and Cd, we can work

backwards to get C0, using an iterative
process.
• This procedure can be extended to any
number of periods.
 Numerical Illustration

• Let the current stock price be 100.

• Consider a call option with two periods to
expiration and an exercise price of 100.
• Assume that given a stock price, the price
next period can be 20% more or 20% less.
• Let the risk-less rate of interest be 5%.
• The stock price tree will look as follows.
 The Stock Price Tree
144
120

100 96

80 64

T-2 T-1 T
 Illustration (Cont…)

• p = 0.625 and 1-p = .375.

• Cuu = Max[0, 144- 100] = 44
• Cud = Max[0, 96-100] = 0
• Cdd = Max[0,64-100] = 0
Illustration (Cont…)
 Impact of Time to Expiration

• As you can see, the value of a two period

call is greater than that of a one period call.
• Obviously, because European call options
always have a non-negative time value.
 Pricing European Puts

• We will illustrate the procedure for the one

period case.
• The procedure is similar to the one used for
call options.
• It can easily be extended to the multi-period
case.
 European Puts (Cont…)

• Assume that we have a stock with a price of

S0, which can either go up to uS0 or go
down to dS0.
• Consider a one-period put option with an
exercise price of E.
• Pu = Max[0, E – uS0]
• Pd = Max[0, E – dS0]
 European Puts (Cont…)
• Using similar arguments, we can show that:

and
 European Puts (Cont…)

• p and 1-p, have the same definitions as

before.
 Numerical Illustration

• We will use the same data as before.

• That is: S0 = E = 100
• u = 1.20; d = 0.80; r = 1.05
• Pu = Max[0, 100 – 120] = 0
• Pd = Max[0,100 – 80] = 20
Illustration (Cont…)
 Extension to the Multiperiod
Case

• In the case of a call option with N periods

left to expiration:
 European versus American Puts

• We will consider the same data used for the

earlier example.
• That is, the current stock price is equal to
the exercise price is equal to 100.
• Every period the stock price can increase by
20% or decline by 20%.
• The riskless rate is 5%.
 Puts (Cont…)

• Consider puts with 3 periods to expiration.

• The stock price tree can be expressed as
follows.
 Stock Price Tree
172.8

144

120
115.2
96
100
80 76.8
64
51.2
Valuing a European Put
European Put (Cont…)
 Valuing an American Put

• In this case, at each node, we have to

compare the model value with the intrinsic
value of the option.
• The greater of the two values should be
used for subsequent calculations.
• At uuS0, the model value is zero and so is
the intrinsic value.
 American Puts (Cont…)

• At udS0 the model price is 8.2857 and the

intrinsic value is 4.
• So we will take the model value.
• Thus Pu,T-1 is identical for both European as
well as American puts.
• At ddS0 the model price is 31.2381.
• The intrinsic value is however 36.
 American Puts (Cont…)

• Therefore:
• Pd,T-1 = .625 x 8.2857 + .375 x 36
--------------------------------
1.05

= 17.7891
 American Puts (Cont…)

• At dS0, the intrinsic value is 20, which is

greater than 17.7891.
• Therefore:
P0 = .625 x 2.9592 + .375 x 20
------------------------------- = 8.9043
1.05
 American Puts (Cont…)

• Even at this last stage, the model value must

be compared with the intrinsic value.
• In this case the intrinsic value is zero.
• So the option will be valued at 8.9043.
• Not surprisingly the American put is valued
at a higher premium than the European put.