Binomial Trees

Binomial Trees
Chapter 11
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 11.1
A Simple Binomial Model
lA stock price is currently $20

l In three months it will be either $22 or $18
Stock Price = $22
Stock price = $20

Stock Price = $18
A Call Option (Figure 11.1, page 242)
 A 3-month call option on the stock has a strike

price of 21.

Stock Price = $22

Option Price = $1
Stock price = $20
Option Price=?
Stock Price = $18
Option Price = $0
Setting Up a Riskless Portfolio
l Consider the Portfolio: long ∆ shares
short 1 call option
22∆ – 1

l Portfolio is riskless when 22∆ – 1 = 18∆ or

18∆
 ∆ = 0.25
Valuing the Portfolio
(Risk-Free Rate is 12%)
l The riskless portfolio is:

 long 0.25 shares short
1 call option
l The value of the portfolio in 3 months is
22 × 0.25 – 1 = 4.50
l The value of the portfolio today is
4.5e –0.12 × 0.25 = 4.3670
Valuing the Option
l The portfolio that is
 long 0.25 shares short
1 option
 is worth 4.367
l The value of the shares is
5.000 (= 0.25 × 20 )
l The value of the option is therefore
0.633 (= 5.000 – 4.367 )
Generalization (Figure 11.2, page 243)
 A derivative lasts for time T and is

dependent on a stock
S0u
ƒu
S0
ƒ S0d
ƒd
Generalization
(continued)
l Consider the portfolio that is long ∆ shares and short 1

derivative

S0u∆ – ƒu
l
l 0d∆ ––ƒƒ
The portfolio is riskless when SS0u∆ u d= S0d∆ – ƒd or
ƒu − f d
∆=
S 0u − S 0 d
Generalization
(continued)
l Value of the portfolio at time T is

S0u∆ – ƒu
l Value of the portfolio today is
(S0u∆ – ƒu)e–rT
l Another expression for the
portfolio value today is S0∆ –
f
l Hence ƒ = S0∆
– (S
Options, Futures, and Derivatives–
Other u∆ 6thƒ )e
Edition,
–rT
Copyright © John C. Hull 2005 11.9
0 u
Generalization
(continued)
l Substituting for ∆ we obtain

 ƒ = [ pƒu + (1 – p)ƒd ]e–rT

 where
e −d rT
p=
u −d
p as a Probability
l It is natural to interpret p and 1-p as probabilities of

up and down movements
l The value of a derivative is then its expected payoff
in a risk-neutral world discounted at the risk-free
rate
S0u
p ƒu
S0
ƒ ( S0d
1 –
p) ƒd
Risk-neutral Valuation
l When the probability of an up and down
movements are p and 1-p the expected stock
price at time T is S0erT
l This shows that the stock price earns the risk-
free rate
l Binomial trees illustrate the general result that to
value a derivative we can assume that the
expected return on the underlying asset is the
risk-free rate and discount at the risk-free rate
l This is known as using risk-neutral valuation
Original Example Revisited
S0u = 22

p ƒu = 1
S0
l
ƒ
Since p is the probability that gives a return on18
the
l
( S d =
1 – rate. We can find it
0
stock equal to the risk-free
from p) ƒd = 0
 20e0.12 × 0.25 = 22p + 18(1 – p )
 which gives p = 0.6523
l Alternatively, we can use the formula
e rT − d e 0.12 ×0.25 − 0.9

p= = = 0.6523
u −d 1.1 − 0.9
Valuing the Option Using Risk-
Neutral Valuation

S0u = 22
52 3 ƒu = 1
0.6
 S0

ƒ
0.34 S0d = 18
77
The value of the option is ƒd = 0

e–0.12 × 0.25 (0.6523× 1 + 0.3477× 0)
 = 0.633
Irrelevance of Stock’s Expected
Return

l When we are valuing an option in terms of the

the price of the underlying asset, the
probability of up and down movements in
the real world are irrelevant
l This is an example of a more general result
stating that the expected return on the
underlying asset in the real world is
irrelevant

A Two-Step Example
Figure 11.3, page 246

24.2
22

20 19.8
l Each time step is 3 months
l K=21, r=12%18
16.2
Valuing a Call Option

24.2
D
3.2
22
B
 20 2.0257 19.8
A E 0.0
1.2823 –0.12
l Value at node B 18 =e
× 0.25 (0.6523× 3.2 + 0.3477× 0)C= 2.0257
0.0 16.2
–0.12
l Value at node A F= e 0.0
× 0.25 (0.6523× 2.0257 + 0.3477× 0)
 = 1.2823

A Put Option Example; K=52
K = 52, time step =

1yr D
72
r = 5%
0
60
B
50 1.4147 48
A E 4
4.1923
40
C
9.4636 32
F 20
What Happens When an Option is
American (Figure 11.8, page 251)
72
D
0
60
B
50 1.4147 48
A E 4
5.0894
40
C
12.0 32
F 20
Delta
l Delta (∆ ) is the ratio of the change

in the price of a stock option to
the change in the price of the
underlying stock
l The value of ∆ varies from node to
node
Choosing u and d
 One way of matching the volatility is to
set
 u =e σ ∆t
 d =1 u =e −σ ∆t
 where σ is the volatility and ∆ t is the

length of the time step. This is the
approach used by Cox, Ross, and
Rubinstein
The Probability of an Up Move
a−d
p=
u−d
a = e r∆t for a nondividen d paying stock

a = e ( r − q ) ∆t for a stock index where q is the dividend
yield on the index
( r − r f ) ∆t
a=e for a currency where rf is the foreign
risk - free rate
a = 1 for a futures contract

Binomial Trees

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Binomial Trees

lA stock price is currently $20

Stock Price = $22

Stock price = $20

 A 3-month call option on the stock has a strike

Stock Price = $22

l Portfolio is riskless when 22∆ – 1 = 18∆ or

l The riskless portfolio is:

 A derivative lasts for time T and is

l Consider the portfolio that is long ∆ shares and short 1

l Value of the portfolio at time T is

l Substituting for ∆ we obtain

l It is natural to interpret p and 1-p as probabilities of

e rT − d e 0.12 ×0.25 − 0.9

l When we are valuing an option in terms of the

K = 52, time step =

l Delta (∆ ) is the ratio of the change

 where σ is the volatility and ∆ t is the

a = e r∆t for a nondividen d paying stock

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