Ch 4.

Binomial Tree Model

I. One-Period Binomial Tree

II. CRR Binomial Tree Model

III. Estimation and Calibration of and

IV. Dividends and Option Pricing

V. Introduction of Combinatorial Method

Appendix A. Binominal Tree Model for Jump-Diffusion Processes

This chapter is devoted to introduce the binomial tree model, which is also known as a
kind of lattice model. The lattice models, such as the binomial tree model introduced in
this chapter or the finite difference method introduced in the next chapter, are popular
numerical methods for option pricing, particularly for pricing American-style derivatives.
They are also flexible since only nominal changes of the payoff function are needed for
dealing with complex, nonstandard option payoff function.

I. One-Period Binomial Tree

Figure 4-1
22
1

20
( = 21)

18
0

t=0 t = 0.25

(i) Constructing a portfolio: long shares and short 1 call

4-1
Figure 4-2

221

20 c

18

(ii) Deciding the value of : if 22 1 = 18 portfolio is riskless

4 = 1
= 0.25
(iii) Hence, at t = 0.25, the value of the portfolio is 22 0.25 1 = 18 0.25 = 4.5
20 c = 4.5 er0.25 , where = 0.25 and r = 0.12
c = 0.633
The emergence of the risk free interest rate r is due to the no-arbitrage argument.

Figure 4-3

S0u cu

S 0 c cu cd
= =
S 0u S 0 d

S0 d cd

t 0 t T

risk free rate r

cu cd
= S0 uS0 d
cu cd u cd
S0 uS0 d 0
S c = (S0 u S0cuS 0d
cu )erT
u cd u cd
c = cud ( cud u cu )erT
u cd rT (cu cd )u (ud)
c = erT ( cud e ud
+ ud u
c )
rT c
c = erT ( (cu cd )e u u+cd u+ucu dcu +cd dcd d
ud
)
rT d)c (erT d)cd
= erT ( (e ud
u
+ (ud)cd
ud
ud
)
rTd erT d
= erT ( eud cu + (1 ud
) cd )
rT d erT d
( eud and 1 ud
are like binomial probabilities, so they are denoted as p and 1 p.)

4-2
 = erT (p cu + (1 p) cd )
For different options, the above equation remains valid, but different payoffs cu and cd
should be considered.

It is worth noting that p is not the probability for cu (or for the upward movement of S).
However, p can be regarded as the probability for cu (or for the upward movement of S)
in the risk neutral world. This is because in the real world, if the expected stock return
is ,
eT d
S0 eT = S0 u q + S0 d (1 q) q = .
ud
Similarly, in the risk neutral world, since the expected returns for all securities are the
same and equal to r,
rT erT d
S0 e = S0 u p + S0 d (1 p) p = .
ud
Therefore, p and 1 p are termed as risk neutral probabilities in the binomial tree fram-
work.

The option pricing equation c = erT (p cu + (1 p) cd ) in the binomial tree model is

consistent with the RNVR because both the expected growth rate of the underlying asset
and the discount rate of the option payoff are the risk free rate.

If the upward and dowanward probabilities in the real world are considered, it is difficult
to identify a proper discount rate to discount the expected payoff of options, i.e.,
c = e?T (q cu + (1 q) cd ).
In practice, for securities with more risk or uncertainty, it should apply higher discount
rates to future expected payoffs. Furthermore, it is well-known that options are riskier
than their underlying assets due to the high-leverage characteristic for investing in options.
So, it is not suited to use the expected return for the underlying asset, , to discount the
expected payoff of the option.
If we reconsider the above numerical example of the one-period binomial tree and
assume = 16%, then we can derive the probability q in the real world to be 0.7041.
Next by equalizing e?T (q cu + (1 q) cd ) to be 0.633, which is the true option value
in the numerical example, we can derive the discount rate for the option to be 42.58%.
In fact, the proper discount rates for expected payoffs of options depend not only on
the expected returns () and volatilities () of underlying assets, but also on the different
K and T of options. As a consequence, it is almost impossible to derive theoretical option
prices directly in the real world.

4-3
II. CRR Binomial Tree Model

Lognormal property
If X is lognormally distributed, i.e., ln X follows a normal distribution with mean =
E[ln X] and variance = var(ln X), then E[X] = eE[ln X]+ 2 var(ln X) , and var(X) =
1

e2E[ln X]+var(ln X) (evar(ln X) 1).

2
ln ST N (ln S0 + ( 2
)T, 2 T )
2
E[ST ] = S0 eT , and var(ST ) = S02 e2T (e T 1)
ln St+t N (ln St + ( 2 )t, 2 t)

2
E[St+t ] = St et

var(St+t ) = S 2 e2t (e2 t 1)
t
2 2 x

St (1 + 2t)(1 + t 1) (because e 1 + x when x 0)
2 2 2 2

= St t + St (2t)( t)

St2 2 t (because the term with t2 is relatively too small)
(In the next paragraph, we will use this property to derive the value of the parameters

u, d, and p in the CRR binomial tree framework.)

Deriving u, d, and p in the CRR (Cox, Ross, and Rubinstein (1979)) binomial tree model,
which is the most common and famous binomial tree model.

Figure 4-4

St u
p

St

1 p
St d

(i) Matching mean: p St u + (1 p) St d = E[St+t ] = St ert

ert d
p= ud

4-4
 2
(ii) Matching variance: var(St+t ) = E[St+t ] E[St+t ]2
2 t = p u2 + (1 p) d2 [p u + (1 p) d]2 (both sides (1/St )2 )
= p u2 + (1 p) d2 p2 u2 2 p (1 p) u d (1 p)2 d2
= u2 (p p2 ) + [(1 p) (1 p)2 ] d2 2 p (1 p) u d
= u2 p (1 p) + (1 p) [1 (1 p)] d2 2 p (1 p) u d
= p (1 p) [u2 2 u d + d2 ] = p (1 p) (u d)2

p (1 p) = p p2 = ert d e2rt 2dert +d2

ud (ud)2

rt rt 2 e2rt +2dert d2

= e uude d+d(ud)2


rt 2rt rt 2rt
= e (ud+2d)ude = e (u+d)ude


(ud)2 (ud)2

2 t = ert (u + d) u d e2rt
Define d = u1 ,
2 t = ert (u + u1 ) u 1
u
e2rt
2 t+1+e2rt
u+ 1
u
= ert
= ert 2 t + ert + ert

rt
e (1 rt), ert (1 + rt), and r 2 t2 0

2 t + 2

u2 ( 2 t + 2)u + 1 = 0

2 t+2 ( 2 t+2)2 4 2 t+2 4 t2 +4 2 t+44
u= 2
= 2
( 4 t2 0)
2
= 2t + 1 t

Since t is far larger than t for a small t,

and 2 is relatively smaller than

we can ignore the first term 2 t
2

1 t

e+ t
(because u > 1 u 6= e t
)

4-5
 Implementation of the CRR binomial tree model:

Figure 4-5

S (n, 0) S0u n d 0

S (2, 0) S0u 2
S ( n, j ) S 0u n j d j
S (1, 0) S0u
S (i, j ) S0u i j d j

S (2,1) S0
S (0, 0) S 0

S (1,1) S0 d
S (2, 2) S0 d 2

1. S (i, j ) S0ui j d j , for 0 j i n and T / n t
2. c( n, j ) payoff for S0u n j d j at maturity
3. c(i , j ) e rt [ p c(i 1, j ) (1 p ) c(i 1, j 1)] (backward induction)
4. For American options, c(i , j ) max(c(i, j ), exercise value for S0ui j d j )
5. c(0,0) is the option price today S ( n, n ) S 0 u 0 d n

rt rt t
Problems of the CRR model: 1) p = e udd = eete
e t
is not necessary in [0, 1] unless
t is small enough. 2) The approximations used to derive var(St+t ) as well as u and d
are vaild only when t is very small.

4-6
 Another binomial tree model: by considering the logarithmic stock price space and the
2
2

constraint of p = 1/2, we can derive p = 12 , u = e(r 2 )t+ t , d = e(r 2 )t t .

Figure 4-6

ln St ln u
p

ln St

1 p
ln St ln d

2
ln St+t N (lnSt + (r 2
)t, 2 t)
2
E[ln St+t ] = ln St + (r 2
)t, var(ln St+t ) = 2 t
Matching mean and variance of ln St+t :
2
p(ln St + ln u) + (1 p)(ln St + ln d) = ln St + (r 2 )t

(1)
2
p(ln St + ln u)2 + (1 p)(ln St + ln d)2 (ln St + (r 2 )t)2 = 2 t (2)
In this model, p is fixed to be 0.5, and only u and d are left as unknowns.
2 2
From Eq. (1), we can derive 0.5 ln u + 0.5 ln d = (r 2 )t ln u = 2(r 2 )t ln d
2
k define D = ln d and = (r 2
)t
ln u = 2 D
Replace ln u in Eq. (2)
0.5(ln St + 2 D)2 + 0.5(ln St + D)2 (ln St + )2 = 2 t
(ln St + 2 D)2 + (ln St + D)2 2(ln St + )2 = 2 2 t
D2 2D + 2 2 t = 0

2 42 4(2 2 t)
D= 2
= t = ln d

ln u = t
( 2

u = e+ t = e(r 2 )t+ t
Because u > d 2

d = e t = e(r 2 )t t

4-7
 Advantages of this alternative binomial tree model: 1) there is no approximation; 2) p
maintains to be a positive number between 0 and 1; 3) the convergence rate is generally
better than the CRR model for pricing plain vanilla options.

Disadvantages of this alternative binomial tree model is due to S0 ud 6= S0 : 1) Since there

is no stock price layer coinciding with the specified barrier price, it is less effecient to
price the family of barrier options. 2) Since there is no stock price layer equal to S0 , it
is impossible to apply a quick method, known as the extended tree model, to estimate
some Greek letters, like , , and .

q
1 t 2
Trinomial Tree u = e 3t
,d = u
, pd = 12 2
(r 2
) + 16 , pm = 23 ,
q
t 2 1
P
pu = 12 2 (r 2 ) + 6
(match (i) mean of St+t , (ii) variance of St+t , (iii) pi = 1,
1 2
(iv) d = u
, (v) pm = 3
, where (iv) and (v) are arbitrarily imposed constraints.)

4-8
 III. Estimation and Calibration of and

E[ln(ST /S0 )] = ( 2 )T
2
6= ln(E[ST /S0 ])
because k assume
2
ln ST ln S0 N (( 2 )T, 2 T ) KT

Assume S1 = S0 e (T = 1 year) E[ST /S0 ] = eKT

(: continuonsly componuding return per annum) E[ST ] = S0 eKT
(S1 is stochastic follows a distribution) (E[ST ] is a known number K is constant)
2
= ln SS01 N ( 2
2 , ) K = = expected growth rate according to
the lognormal property of ST on page 4-5
2

2 is the expected value of the continuously
compounding return per annum

i. Considering two trading days, t and t + 1, i. Considering two trading days, t and t + 1,

we can derive St+1 = St ed and d = ln SSt+1

t
then E[St+1 /St ] = eKd and Kd = ln E[St+1 /St ]

ii. Calculating the average of ln SSt+1

t
for n days, ii. Calculating the average of St+1
St for n days and
d2
the result is the estimation of d 2 . taking the natural log, we can estimate Kd = d
S1
1
n (ln S0 + ln SS21 + + ln SSn1
n
) ln( n1 ( SS10 + S2
S1 + + Sn
Sn1 ))

= n1 (ln R1 + ln R2 + + ln Rn ) = ln( n1 (R1 + R2 + + Rn ))

= n1 (ln(R1 R2 Rn ))
1
= ln(R1 R2 Rn ) n
The geometric average of daily returns The arithemtic average of daily returns
estimate the continuously compounding estimates the daily expected growth rate d
2
return d 2d
St+1
The standard deviation of the series of daily The standard deviation of the series of St
ln SS01 , ln SS12 , . . . , ln SSn1
n
generates the estimation is NOT the estimation of d
of d

Note that the estimated results based on the daily data, i.e., d and d , need to be annualized to derive
the corresponding annual results.

4-9
 Implied volatility (the calibration () of )
For any option pricing function c(S0 , K, T, r, ), S0 is the stock price today, K and T can
be found in the option contract, and r is the risk-free rate corresponding to the time to
maturity T . As for , it is commonly estimated based on the historical stock prices.
However, the market price of an option reflects the consensus of the forward-looking
of market participants and may not equal the theoretical option value based on the
historical . Through equalizing c(S0 , K, T, r, ) and the market option price, it is possible
to calibrate from the forward-looking viewpoint.
The value of satisfying f ( ) c(S0 , K, T, r, )market option price = 0 is called
the implied volatility. Here two root-finding algorithms are introduced to solve for the
implied volatility.

Bisection Method
First find [an , bn ] such that f (an )f (bn ) < 0. The iterative two steps to find [an+1 , bn+1 ]
are as follows.
bn an
(i) Calcuate xn = an + 2
(ii) If f (an )f (xn ) < 0 an+1 = an , bn+1 = xn
else an+1 = xn , bn+1 = bn

Newtons Method
f (xn )
xn+1 = xn f 0 (xn )

Based on the first-order Taylor series: f (x) = f (xn ) + f 0 (xn )(x xn )

(Find the root of f (x), i.e., solve f (x) = 0.)

f (xn ) = f 0 (xn )(x xn ) x = xn+1 = xn ff0(x n)

(xn )

Quadratical convergence:
f 00 ()


According to the second-order Taylor series, f (x) = f (xn ) + f 0 (xn )(x xn ) + 2
2 (x xn ) ,


where is between xn and x.

Solve f (x) = 0:
f (xn ) f 00 ()

x xn + f 0 (xn )
= 2f 0 (xn ) (x xn )2
f 00 ()
x xn+1 = 2f 0 (xn ) (x xn )2



f 00 () f 00 ()
(Suppose | 2f 0 (xn ) | is bounded by a finite number M , i.e., | 2f 0 (xn ) | M < .)


| x xn+1 | M | x xn |2

(The error is smaller than the product of a finite number and the square of the error of

the n-th iteration.)

4-10
IV. Dividends and Option Pricing

This section introduces how to modify the option pricing models if the dividend yield q
or known cash dividends D at the pre-specified time point t are considered:

Table 4-1 Three Different Models for Dividend Payments

Suppose the time Black-Scholes Model Binomial Tree Model

point today is 0 European European American
Model 1: or


Dividend yield
=
=

Model 2:
Known cash
dividends at as a not available Figure 4-8 Figure 4-8
percentage of

Model 3:

Known cash Figure 4-10
or Figure 4-10
dividends at

Model 1: dividend yield q


S0 + paying dividend yield q
It is known that the distributions of ST are the same under
S0 eqT + no dividend payment

Figure 4-7

4-11
 In the Black-Scholes formula, simply replace S0 with S0 eqT
c = S0 eqT N (d1 ) K erT N (d2 )
2
ln(S0 /K)+(rq+ 2 )T
where d1 = , d2 = d1 T
T

2f
As a matter of fact, the original d = ( f
t +
1
2 S 2 2 S 2 )dt
6= r dt
f
new d = d + q ( S S dt) = r dt
f
(where q ( S S dt) is the dividend recived by the portfolio holder)
2
f f 1 f 2 2
t + S (r q)S + 2 S 2 S = rf
(where (r q)S replaces rS of the original PDE)

It is worth noting that in the above PDE, when we consider the dividend yield q, it
does not mean to replace r with r q. In fact, for the underlying asset S, the expected
growth rate is from r to become r q, but the discount rate for the derivative f is still r
because the right-hand side of the above PDE remains rf .

 For the binomial tree model

Method 1: replace S0 with S0 eqT + no dividend payment
Method 2: change the risk neutral probability p

e(rq)t d
p St u + (1 p) St d = St e(rq)t p =
ud
However, during the backward induction phase, we still use r to discount the expected
option value at the next time point, i.e., f = ert [p fu + (1 p) fd ] (For European
options, both above methods generate correct results, but for American options, only the
second method can generate correct results.)

4-12
 Model 2: known cash dividends as a percentage of the stock price at the time point t
(In practice, it is rare for companies to distribute cash dividends in this way.)
 For the Black-Scholes formula, it is unavailable to deal with this problem.
 For the binomial tree model, it is simple to deal with this problem (see Figure 4-8).
Figure 4-8
S0u 4 (1 )

S0u 3 (1 )

S0 u
S0u 2 (1 ) S0u 2 (1 )

S0 S0u (1 )

S0 (1 ) S0 (1 )
S0 d
S0 d (1 )

S0 d 2 (1 ) S0 d 2 (1 )

S0 d 3 (1 )

S0 d 4 (1 )

Model 3: known cash dividends D at time point t

 For the Black-Scholes formula, replace S0 with S0 Dert .
 For the binomial tree model,
Method 1: replace S0 with S0 Dert . However, this method only works for European
options, but it cannot be applied to pricing American options.

S0 + paying D dollars at t
(This is because the distributions of S ( t) are the same under )
S0 Dert + no dividend payment
Method 2: deduct the known dividend D from all stock prices on the divided payment
date. This method cannot work because it makes the tree to be non-recombined.
Figure 4-9

S 0u 2 D
S0 u

S0
S0 D

S0 d

S0 d 2 D

4-13
Method 3: this method can maintain the recombined feature of the binomial tree
Figure 4-10
S0u 5

S0u 4

S0u 3 S0u 3

S0u 2 S0u 2

S0u S0u S0u

S0 S0
S0

S0 d S0 d S0 d

S0 d 2 S0 d 2

S0 d 3 S0 d 3

S0 d 4

S0 d 5

t0 0 t1 t2 t3 t t4 t5

De r (t t0 ) + De r (t t1 ) De r (t t2 ) De r (t t3 )

Define S0 = S0 Der(tt0 ) = S0 Dert

Step 1: build S -tree following the traditional way, but it should be noted that in
theory = S0 /(S0 Der(tt0 ) ), where is the volatility for the
stochastic part of the stock price and is the total volatility of the stock
price.
(For a different volatility , we should derive new u , d , and p in theory.
In practice, however, it is rare to calculate . The first reason is that the
difference between and is minor. The second reason is that since
is an estimated value based on the historical data, performing the above
adjustment will not necessarily lead to a better estimation for in the
forward-looking sense.)
Step 2: for ti < t, replace Sti with Sti + Der(tti )
(Since S0 = S0 Der(tt0 ) = S0 Dert in Step 1, S -tree is the same as
the tree in Method 1 after t, which formulates the stock price process after
the dividend payment appropriately. However, the stock prices before t are
not consistent with the stock price process before the dividend payment,
i.e., S0 6= S0 and E[Sti ] 6= E[Sti ] for ti < t. So, the adjustment in Step 2
should be performed.)

4-14
 Currency option
 Replace the dividend yield q with the foreign risk-free rate rf
(Because the underlying asset S is a dollar of the foreign currency in domestic dollars,
and holding the foreign currency can earn the foreign risk-free rate, a foreign currency
is analogous to a stock paying a known dividend yield.)

 c = Serf T N (d1 ) KerT N (d2 )

2
ln(S/K)+(rrf + 2 )T
where d1 = , d2 = d1 T
T

Futures options
 Call holders: have the right to enter a long position futures with the deliver price to
be FT and receive cash FT K if FT K, where FT is the latest settlement futures
price before T (usually FT is the closing price on the date T ) and K is the strike price
in futures options.

 Put holders: have the right to enter a short position of futures with the deliver price
to be FT and receive cash K FT if FT K.

Since the futures is worth zero when it is initiated (in the above cases, it is at T ), it
can be concluded that the payoff of futures option is similar to that of exercising plain
vanilla options, and the only difference is to replace ST with FT . This observation helps
us to develop the pricing formula for futures options following the same way to develop
the option formula for plain vanilla options.

4-15
  Black-Scholes formula for futures options:
dF
Suppose the futures price follows the geometric Brownian motion: F = dt + dZ
c(F, t) is the call on futures, and according to the Itos lemma
2c
dc = ( c
t +
c
F F + 1
2
2 2 c
F 2 F )dt + F F dZ
c
Construct portfolio = c + ( F ) F = c (the initial value of futures is 0)
c 1 2c
d = dc + ( F ) dF = ( c 2 2
t + 2 F 2 F )dt
= rdt = r(c)dt
2
c 1 c 2 2
t + 2 F 2 F = rc
c
(Comparing with the PDE for stock options, these is no such term F (r q)F .)
So, setting q = r and S0 = F0 in the Black-Scholes formula to derive the formula for
futures options.)
2
ln(F0 /K)+ 2T
c = erT [F0 N (d1 ) KN (d2 )], where d1 = and d2 = d1 T
T

 Binomial Tree
e(rq)t d 1d
Because q = r, p = ud = ud (but we still use r as the discount rate)

Another way to derive p
Figure 4-11
payoffT ( )





( F0u F0 ) cu




Futures (at F0 ) cu cd


= =
1 c

F0u F0 d
value( ) c


( F0 d F0 ) cd




c = [(F0 u F0 ) cu ]erT (the initial value of the futures is 0)


c = erT (p cu + (1 p) cd ), where p = ud
1d

The Black-Scholes model as well as the binomial tree model are versatile models:
Treat stock index, currency, and futures like a share of stock paying a dividend yield q
For stock index options: q = average dividend yield on the index over the option life
For currency options: q = rf
For futures options: q = r

4-16
V. Introduction of Combinatorial Method

Combinatorics () is a branch of pure mathematics concerning the study of dis-

crete (and usually finite) objects. Aspects of combinatorics include counting the objects
satisfying certain criteria, deciding when the criteria can be met, or finding largest,
smallest, or optimal objects.

Combinatorial method for European options

Based on the binomial tree framework, applying the combinatorial method is far faster
than the backward induction procedure. In fact, it is not necessary to build the binomial
tree in the combinatorial method, which is another advantage of the combinatorial method
because is can save memory space for computer programming.

Figure 4-12

S0 u n d 0
S0 u n 1 d
M
M

S0 S0 u n j d j
M
M K
M
M
S0 u1 d n 1
S0 u 0 d n

T is partitioned
into n time steps

n
   
rT
P n nj j nj j n
European option value = e p (1p) max(S0 u d K, 0), where ,
j=0 j j

also denoted as Cjn , is the combination of j from n, u = e t
, d = e t
, and p =
e(rq)t d
ud
.

For the binomial tree model, its complexity is O(n2 ), whereas for the above combina-
torial method, the complexity is O(n). The difference of required computational time is
substantial for a large number of n, e.g., n > 5000.

4-17
Appendix A. Binominal Tree Model for Jump-Diffusion Processes

The content in this appendix belongs to the advanced content.

Binomial tree model for the jump-diffusion process in Amin (1993):

 Consider Mertons (1976) lognormal jump-diffusion process as follows.
dS
S
= (r q KY )dt + dZ + (Y 1)dq,
where KY = E[Y 1] and ln Y N (J , J2 ). By the Itos lemma,
d ln S = (r q 21 2 KY )dt + dZ + ln Y dq = dt + dZ + ln Y dq

 The lattice model proposed by Amin (1993)

Figure 4-13

ln S t ln S0 t 2 t ln S i t ln S 0 i t 2 t
ln St ln S0 t t ln S it ln S 0 i t t
ln S0 ln St ln S0 t ln S it ln S 0 i t
ln St ln S0 t t ln S it ln S 0 i t t
ln S t ln S0 t 2 t ln S it ln S 0 i t 2 t

0 t i t nt T

4-18
 Backward induction:
Figure 4-14

ln S t t ln S t t M J t

ln S t t ln S t t 2 t
ln S t t ln S t t t
ln S t ln St t ln St t
ln S t t ln S t t t
ln S t t ln S t t 2 t

ln S t t ln S t t M J t

Define the branching probabilities as follows.

prob(ln St+t ln St = t + t) = (1 t)Pu + tN (k)
P (k) = prob(ln St+t ln St = t t) = (1 t)Pd + tN (k) ,
prob(ln St+t ln St = t + k t) = tN (k), for MJ k MJ


where N (k) = N ((t + (k + 12 ) t J )/J ) N ((t + (k 21 ) t J )/J )

if k 6= MJ , MJ int( 3
J ), N (M
t J ) = 1 N ((t + (MJ 1
2
) t J )/J ), and
N (MJ ) = N ((t (MJ 12 ) t J )J ).
(Note that tN (k) can fully capture the effect of the jump component ln Y dq of
d ln S.)

4-19
 Determine Pu and Pd by matching the mean and variance of the remaining diffusion process,
d ln S = dt + dZ
t

Pu St u + Pd St d = St e

Pu St2 u2 + Pd St2 d2 (Pu St u + Pd St d)2 = St2 2 t,

P +P =1
u d

where u = et+ t
and d = et t
. Analogous with the CRR binomial tree model,
we can infer
et d
Pu = ud
.

However if we consider the probabilities of (1 t)Pu and (1 t)Pd for the upward
and downward branches, respectively, when the jump component is introduced. The mean
and variance generated by the probabilities of (1 t)Pu and (1 t)Pd are no more
St et and St2 2 t.
t

(1 t)Pu St u + (1 t)Pd St d = (1 t)St e

(1 t)Pu St2 u2 + (1 t)Pd St2 d2 [(1 t)Pu St u + Pd St d]2 (1 t)St2 2 t,
(1 t)P + (1 t)P = (1 t)

u d

For the variance equation, it can be rewritten as (1 t)[Pu St2 u2 + Pd St2 d2 (1

t)(St et )2 ] (1 t) St2 2 t,
p if t is smallsuch that (1 t) 1.
So, the standard deviation become (1 t)St t. By comparing with the mean,
(1 t)St et , one can find that the deviation of the mean from its true value p is more
serious than the deviation of the standard deviation from its true value because (1 t)
is closer to 1 than (1 t) when t is small.
To offset the above undesirable effects, we should solve Pu and Pd in the following system
of equations.
t

Pu St u + Pd St d = S1t
te

St2 2 t
Pu St2 u2 + Pd St2 d2 (Pu St u + Pd St d)2 = 1t

P u + Pd = 1

In Amin (1993), only the adjustment for the mean is considered, and thus the probability
Pu can be derived as
et
1t
d
Pu = ud
.

4-20
 Option value of a node can be expressed as
Option value of ln St
P
= P (k) (option value for ln St+t = ln St + t + k t)
MJ kMJ

 If the adjustment for the variance is also considered, one can adjust the grid size
of the
t+ t

multinomial tree to achieve this goal. By defining = 1t , u = e
, d =


et t , one can derive the following tree structure and the corresponding branching
probabilities.
Figure 4-15

ln S t t ln S t t M J * t

ln S t t ln S t t 2 * t
ln S t t ln S t t * t
ln S t ln St t ln St t
ln S t t ln S t t * t
ln S t t ln S t t 2 * t

ln S t t ln S t t M J * t

prob(ln St+t ln St = t + t) = (1 t)Pu + tN (k)

P (k) = prob(ln St+t ln St = t t) = (1 t)Pd + tN (k) ,

prob(ln St+t ln St = t + k t) = tN (k), for MJ k MJ


where N (k) = N ((t+(k+ 12 ) tJ )/J )N ((t+(k 21 ) tJ )/J ) if k 6=

MJ , MJ int( 3Jt ), N (MJ ) = 1N ((t+(MJ 12 ) tJ )/J ), N (MJ ) =
e
t
d
N ((t (MJ 2 ) t J )/J ), and Pu = u d and Pd = 1 Pu .
1 1t

4-21