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One-Period Binomial Model for Derivatives

The document explains the valuation of derivatives using a one-period binomial model, focusing on call options. It provides examples of calculating the hedge ratio, risk-neutral probabilities, and the present value of cash flows to determine the no-arbitrage price of a call option. The binomial model is highlighted as a versatile tool for pricing various derivatives.

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7 views5 pages

One-Period Binomial Model for Derivatives

The document explains the valuation of derivatives using a one-period binomial model, focusing on call options. It provides examples of calculating the hedge ratio, risk-neutral probabilities, and the present value of cash flows to determine the no-arbitrage price of a call option. The binomial model is highlighted as a versatile tool for pricing various derivatives.

Uploaded by

harsoftware3
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Derivatives

Derivatives
Valuing a Derivative Using a One-Period
Binomial Model

LOS a Explain Valuation Using a One-Period Binomial Model

A One-Period Binomial Model

Today 1 year Call Option at 55

$60 $5
up-move
S0 = $50
$42
down-move 0

© Kaplan, Inc. 2

1
LOS a Explain Valuation Using a One-Period Binomial Model

Example: Valuing a Call Option


Find stock/call ratio for portfolio that has same value with up-move or
down-move

ValueUP = hSUP – CUP = hSDN – CDN = ValueDN


h(60) – 5 = h(42) – 0 h(60 – 42) = 5 h= 0.278

Hedge ratio is 0.278 shares for each short call


VUP = 0.278(60) – 5 = 11.68 VDN = 0.278(42) = 11.68
© Kaplan, Inc. 3

LOS b Describe Valuation Using a One-Period Binomial Model

Valuing a Call Option


0.278 Stock – Call has a payoff of 11.68 at the end of one year
regardless of the stock price move

With Rf = 3%, V0 = 11.68/1.03 = 11.34


Given V0 = 11.34, we have 0.278(50) – C0 = 11.34
C0 = 2.56 the no-arbitrage price of the call at t = 0

© Kaplan, Inc. 4

2
LOS b Describe Valuation Using a One-Period Binomial Model

Example: Risk-Neutral Pricing


U = up-move factor = 1.15
D = down-move factor = 0.87

U = risk-neutral probability of up-move = 1+ R f – D = 0.715


U–D
D = risk-neutral probability of down-move = 1 – U = 0.285

Rf = 7%; S0 = $30

© Kaplan, Inc. 5

LOS b Describe Valuation Using a One-Period Binomial Model

Example: Risk-Neutral Pricing


One-period binomial tree for stock price

$30 × 1.15 = $34.50

S = $30 up-move
0
$30 × 0.87 = $26.10

Today 1 year
down-move

© Kaplan, Inc. 6

3
LOS b Describe Valuation Using a One-Period Binomial Model

Example: Risk-Neutral Pricing


With an up-move:
 Stock increases to $34.50
 Payoff to call with $30 strike = $4.50

With a down move:


 Stock falls to $26.10
 Option will pay $0 (option out-of-the-money)

© Kaplan, Inc. 7

LOS b Describe Valuation Using a One-Period Binomial Model

Example: Risk-Neutral Pricing

S = $30 × 1.15 = $34.50


π U= 0.715 C = max (0, $34.50 – $30) = $4.50

S0 = $30

π D= 0.285 S = $30 × 0.87 = $26.10


C = max (0, $26.10 – $30) = $0
Today 1 year

© Kaplan, Inc. 8

4
LOS b Describe Valuation Using a One-Period Binomial Model

The Binomial Model


Call value = PV of cash flows (discounted at Rf):

C0 =
 $4.50 × 0.715  +  $0 × 0.285 
1.07
$3.22
= = $ 3.00
1.07
These models can be used to price a variety of derivatives.

© Kaplan, Inc. 9

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