Binomial Option Pricing
Professor P. A. Spindt
A simple example
A stock is currently priced at $40 per
share.
In 1 month, the stock price may
go up by 25%, or
go down by 12.5%.
A simple example
Stock price dynamics:
t = now t = now + 1 month
$40x(1+.25) = $50 up state
$40
$40x(1-.125) = $35 down state
Call option
A call option on this stock has a strike
price of $45
t=0 t=1
Stock Price=$50;
Call Value=$5
Stock Price=$40;
Call Value=$c
Stock Price=$35;
Call Value=$0
A replicating portfolio
Consider a portfolio containing shares
of the stock and $B invested in risk-free
bonds.
The present value (price) of this portfolio is
S + B = $40 + B
Portfolio value
t=0 t=1
$50 + (1+r/12)B up state
$40 + B
$35+ (1+r/12)B down state
A replicating portfolio
This portfolio will replicate the option if
we can find a and a B such that
$50 + (1+r/12) B = $5 Up state
and
$35 + (1+r/12) B = $0 Down state
Portfolio payoff = Option payoff
The replicating portfolio
Solution:
= 1/3
B = -35/(3(1+r/12)).
Eg, if r = 5%, then the portfolio contains
1/3 share of stock (current value $40/3 =
$13.33)
partially financed by borrowing
$35/(3x1.00417) = $11.62
The replicating portfolio
Payoffs at maturity
up state down state
Stock Price $ 50.00 $ 35.00
1/3 Share $ 16.67 $ 11.67
Bond Repayment $ 11.67 $ 11.67
Net portfolio $ 5.00 $ -
The replicating portfolio
Since the the replicating portfolio has
the same payoff in all states as the call,
the two must also have the same price.
The present value (price) of the
replicating portfolio is $13.33 - $11.62 =
$1.71.
Therefore, c = $1.71
A general (1-period) formula
Cu − Cd SuCd −SdC u
Δ= B=
Su − Sd (1+ r)(Su −Sd )
pCu + (1− p)Cd
c = ΔS+ B =
1+ r
r −d
p=
u −d
An observation about
As the time interval shrinks toward
zero, delta becomes the derivative.
Cu − Cd ∂C
Δ= →
Su − Sd ∂S
Put option
What about a put option with a strike
price of $45
t=0 t=1
Stock Price=$50;
Put Value=$0
Stock Price=$40;
Put Value=$p
Stock Price=$35;
Put Value=$10
A replicating portfolio
t=0 t=1
$50 + (1+r/12)B up state
$40 + B
$35+ (1+r/12)B down state
A replicating portfolio
This portfolio will replicate the put if
we can find a and a B such that
$50 + (1+r/12) B = $0 Up state
and
$35 + (1+r/12) B = $10 Down state
Portfolio payoff = Option payoff
The replicating portfolio
Solution:
= -2/3
B = 100/(3(1+r/12)).
Eg, if r = 5%, then the portfolio contains
short 2/3 share of stock (current value
$40x2/3 = $26.66)
lending $100/(3x1.00417) = $33.19.
Two Periods
Suppose two price changes are possible
during the life of the option
At each change point, the stock may go
up by Ru% or down by Rd%
Two-Period Stock Price
Dynamics
For example, suppose that in each of
two periods, a stocks price may rise by
3.25% or fall by 2.5%
The stock is currently trading at $47
At the end of two periods it may be
worth as much as $50.10 or as little as
$44.68
Two-Period Stock Price
Dynamics
$50.10
$48.53
$47 $47.31
$45.83
$44.68
Terminal Call Values
At expiration, a call with a strike
price of $45 will be worth: Cuu =$5.10
$Cu
$C0 Cud =$2.31
$Cd
Cdd =$0
Two Periods
The two-period Binomial model formula
for a European call is
p2C UU + 2p(1− p)CUD + (1− p)2 C DD
C= 2
(1+ r)
Example
TelMex
TelMex Jul
Jul 45
45 143
143 CB
CB 223//1616 --5//1616 47
3 5
47 2,703
2,703
Two
TwoPeriod
PeriodBinomial
BinomialModel
Model
Call Option Price Calculator
Call Option Price Calculator
Stock Price
Stock Price $47.00
$47.00
Exercise
ExercisePrice
Price $45.00
$45.00
Years
YearstotoMaturity
Maturity 0.08
0.08
Risk-free
Risk-freeRate
Rate(per
(perannum)
annum) 5.00%
5.00%
Ru
Ru 3.25%
3.25%
Rd
Rd -2.50%
-2.50%
pp 47.10%
47.10%
Stock
StockValue
ValueininUp
UpUpUpState
State $$50.10
50.10
Call Value in Up Up State
Call Value in Up Up State $$ 5.10
5.10
Stock
StockValue
ValueininDown
DownUp UpState
State $$47.31
47.31
Call Value in Down Up State
Call Value in Down Up State $$ 2.31
2.31
Stock
StockValue
ValueininDown
DownDown
DownState
State $$44.68
44.68
Call
CallValue
ValueininDown
DownDown
DownState
State $$ - -
Call
CallValue
Value $$ 2.28
2.28
Estimating Ru and Rd
According to Rendleman and Barter you can
estimate Ru and Rd from the mean and
standard deviation of a stock’s returns
μt t
Ru = exp( n + σ n)−1
μt t
Rd = exp( n −σ n)−1
Estimating Ru and Rd
In these formulas, t is the option’s time to expiration
(expressed in years) and n is the number of intervals
t is carved into
μt t
Ru = exp( n + σ n)−1
μt t
Rd = exp( n −σ n)−1
For Example
Consider a call option with 4 months to
run (t = .333 yrs) and
n = 2 (the 2-period version of the
binomial model)
For Example
If the stock’s expected annual return is
14% and its volatility is 23%, then
Ru = exp(.14× .332 + .23 .332)−1= .1236
For Example
The price of a call with an exercise price of $105 on a stock
priced at $108.25 Two Period Binomial Model
Call Option Price Calculator
Stock Price $108.25
Exercise Price $105.00
Years to Maturity 0.33
Risk-free Rate (per annum) 7.00%
Ru 12.36%
Rd -6.79%
p 41.49%
Stock Value in Up Up State $ 136.66
Call Value in Up Up State $ 31.66
Stock Value in Down Up State $ 113.37
Call Value in Down Up State $ 8.37
Stock Value in Down Down State $ 94.05
Call Value in Down Down State $ -
Call Value $ 9.30
Anders Consulting
Focusing on the Nov and Jan options,
how do Black-Scholes prices compare
with the market prices listed in case
Exhibit 2?
Hints:
The risk-free rate was 7.6% and the expected
return on stocks was 14%.
Historical Estimates: IBM = .24 & Pepsico = .38