THE HANG SENG UNIVERSITY OF HONG KONG

DEPARTMENT OF MATHEMATICS, STATISTICS AND INSURANCE

AIN4220 Derivatives Valuation (Spring 2025)

Chapter 6 Binomial Tree for Option Pricing

6.1 One-period binomial tree

Binomial pricing assumes that the stock price can change to either an up value or a down value (only two possible prices).

We have two instruments to use in replicating an option: shares of stock and a position in risk-free bonds (i.e., borrowing
or lending). We need to find a portfolio consisting of ∆ shares of stock and a dollar amount B in lending, such that the port-
folio imitates the option whether the stock rises or falls. We will suppose that the stock has a continuous dividend yield of δ ,
which we reinvest in the stock. Thus, if you buy one share at time t, at time t + h you will have eδ h shares. Also, let r be the
continuously compounded annual interest rate. If you buy one dollar of risk free interest bond at time t, at time t + h you will
have erh dollars.

Let S be the stock price today. We write the stock price as uS when the stock goes up and as dS when the price goes
down.

Let Cu and Cd represent the value of the option when the stock goes up or down, respectively. The problem is to solve for

∆ and B such that our portfolio of ∆ shares and B in lending duplicates the option payoff:

(∆ × dS × eδ h ) + (B × erh ) = Cd ,
(∆ × uS × eδ h ) + (B × erh ) = Cu .

Solving these two equations gives

Cu −Cd
∆ = e−δ h ,
S(u − d)
uCd − dCu
B = e−rh .
u−d
The cost of creating the option is the net cash required to buy the shares and bonds. Thus, the cost of the option is:
!
−rh e(r−δ )h − d u − e(r−δ )h
∆S + B = e Cu +Cd .
u−d u−d

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6.1.1 Risk-neutral pricing
Let
e(r−δ )h − d
p∗ = . (6.1.1)
u−d
p∗ is called the risk-neutral probability of an increase in the stock price. One can verify that u > e(r−δ )h > d and therefore
0 < p∗ < 1, so that
∆S + B = e−rh [p∗Cu + (1 − p∗ )Cd ].
Because p∗ and 1− p∗ are both positive and sum to one, the term p∗Cu +(1− p∗ )Cd looks like an expected cash flow computed
using the risk-neutral probability. This expected cash flow is then discounted using the risk-free rate.
Exercise 6.1.1. (Exercise 10.23 in textbook)

6.2 Constructing a binomial tree

In this section, we explain how the binomial tree is constructed. We first review some properties of continuously compounded
returns and define volatility. We then explain the constrution of u and d.

6.2.1 Volatility
Suppose that the continuously compounded return over month i is rmonthly,i . Then the annual continuously compounded return
is
12
rannual = ∑ rmonthly,i
i=1

Assume that returns are uncorrelated over time. The variance of the annual continuously compounded return is
!
12
Var(rannual ) = Var ∑ rmonthly,i
i=1

Assume that each month has the same variance of returns. If we let σ 2 denote the annual variance and σmonthly
2 denote the
monthly variance, then
σ
σmonthly = √
12

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To generalize this formula, if we split the year into n periods of length h (i.e. h = 1/n), the standard deviation over the period
of length h is √
σh = σ h

6.2.2 Constructing u and d

If there were no uncertainty about the future stock price, the stock price next period must equal the forward price, i.e.

St+h = St e(r−δ )h .

We incorporate uncertainty into the stock return using volatility, which measures how sure we are that the stock rate of return
will be close to the expected rate of return. We model the stock price evolution by adding uncertainty to the forward price:
√
uSt = St e(r−δ )h+σ h
,
√
(r−δ )h−σ h
dSt = St e .

Therefore,
√
u = e(r−δ )h+σ h
,
√
(r−δ )h−σ h
d=e ,

where r is the continuously compounded annual interest rate, δ is the continuous dividend yield, σ is the annual volatility, and
h is the length of a binomial period in years. These u and d are what we will use to construct binomial trees. We will refer to
such a tree as a ”forward tree”.

6.2.3 One-period example with a forward tree

Suppose that the current stock price is $41, the annual volatility is 30%, and there is no dividend. Given that the continuously
compounded annual interest rate is 8%. The up and down movements of the stock after 1 year are:

Because the binomial tree is different from that in Figure 10.1, the option price will be different as well. In this case,

$59.954
u= = 1.4623,
$41
$32.903
d= = 0.8025.
$41
For a call with strike price $40, we have

Cu = $59.954 − $40 = $19.954,

Cd = 0.

The risk-neutral probability of an increase in the stock price:

e0.08 − 0.8025
p∗ = = 0.4256.
1.4623 − 0.8025
The option price is
C = e−0.08 (0.4256(19.954) + 0.5744(0)) = 7.8395.

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6.2.4 Two or more binomial periods
Let us re-examine the 1-year European call option in Figure 10.3. Suppose that 1 year is now divided into three binomial
periods. The length of a period is h = 1/3. We will assume that r = 0.08 and σ = 0.3 as in Figure 10.3. In this case, To
compute the stock price:
q
0.08( 31 )+0.3 13
u=e = 1.2212,
q
0.08( 13 )−0.3 13
d=e = 0.8637.

The option price is computed by working backward. The risk-neutral probability of the stock price going up in a period is
1
e0.08( 3 ) − 0.8637
= 0.4568.
1.2212 − 0.8637
The option price at the node where S = $43.246, for example, is computed as
1
e−0.08( 3 ) ($12.814(0.4568) + $0(1 − 0.4568)) = $5.7.

Exercise 6.2.1. (Exercise 10.14 from textbook)

6.3 European option v.s. American option

Figure 10.6 shows the binomial tree for a European put option with 1 year to expiration and a strike of $40 when the stock
price is $41.

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5
Figure 10.7 presents the binomial tree for the American version of the put option valued in Figure 10.6. Notice that at the node
where the stock price is $30.585, the option is worth $8.363 when held until expiration, but it would be worth $40 - $30.585
= $9.415 if exercised at that node. Thus, it is optimal to exercise the Amercian put at that node.

Exercise 6.3.1. (Exercise 10.12 from textbook)

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6.4 Options on currencies
With a currency with spot price x0 , the forward price is F0,h = x0 e(r−r f )h , where r f is the foreign interest rate. Thus, we
construct the binomial tree using
√
ux = xe(r−r f )h+σ h
,
√
(r−r f )h−σ h
dx = xe .

The risk-neutral probability of an up move is given by

e(r−r f )h − d
p∗ = .
u−d
Exercise 6.4.1. (Exercise 10.16 from textbook)

6.5 Remark
The teaching material in this chapter is extracted from the textbook McDonald, R. L. (2013). Derivatives Markets. (3rd ed.).
Pearson.