THE BINOMIAL OPTION PRICING MODEL

If there were not derivatives, there would be no bank loans at all today, because people

want to get fixed-rate 30-year loans, but banks don't want to keep 30-year loans on their

books.

Jeff Greene

________________________________________________________________________

The Binomial Option Pricing Model1 is an extremely popular, robust method of calculating

option prices. Its chief advantages are its flexibility to incorporate market realities, and its

simplicity.

“…whenever stock price movements conform to a discrete binomial process, or to a limiting

form of such a process, options can be priced solely on the basis of arbitrage

considerations.”(Cox, Ross, & Rubinstein, 1979)

History:

Thales of Miletus (ancient Greek philosopher, before Socrates) bought rights to olive presses

in the 6th century BC. This is the first recorded options contract in history.

In his PhD thesis (The Theory of Speculation, published in 1900), Louis Bachelier presented

a stochastic2 analysis of stock & option markets. He is considered a pioneer in the field of

financial mathematics.

1
The paper was titled, “Option Pricing: A Simplified Approach”
2
Unpredictable because of a random variable. Greek “stokhos” = aim.

Page 2 of 16
Introduction:

An option is a financial derivative, a contract which confers on the buyer, the right, but not

the obligation, to purchase or sell a specified quantity of the underlying asset, at a specified

price, on or before its expiry.

The seller on the other hand, has the obligation, but not the right, to deliver or buy as above,

on exercise of the option by the buyer.

For this peculiarly one-sided contract, where one party retains the rights to all benefits, while

the other is bound to make good, the buyer pays a premium upfront, to the seller of the

option.

This premium is the price paid by the buyer to enjoy benefits without risk; & it is the price

received by the seller, to accept downside risks in the contract.

One could have options on stocks, commodities, weather, credit events & just about anything.

Correctly pricing an option is a tricky affair & has led to the downfall of even the most

brilliant minds.

A Call Option3 is an option in which the buyer has the right to take delivery of the

underlying (at her discretion) & the seller must sell the underlying, if the option is exercised.

(Quantity, price, specifications, are all part of the contract)

A Put Option confers on the buyer, the right to sell the underlying; the seller must buy the

underlying when this right is invoked.

3
For a detailed introduction to Financial Derivatives, the interested reader is requested to visit the Knowledge
Bank of The Institute of Cost Accountants of India, for my research article. [Link]
Bank/upload/[Link]

Page 3 of 16
_____________________________________________________________________

The Binomial Option Pricing Model is an extremely popular, robust method of calculating

option prices. Its chief advantages are its flexibility to incorporate market realities, and its

simplicity.

“…whenever stock price movements conform to a discrete binomial process, or to a limiting

form of such a process, options can be priced solely on the basis of arbitrage

considerations.”(Cox, Ross, & Rubinstein, 1979)

Assumptions

* Stock price follows a multiplicative binomial process over discrete time periods

* There are two possible outcomes at the end of each time period, up and down (from

the current price)

* Investors are risk-neutral

* Markets are efficient

* Transaction costs, taxes, bid-ask spreads and margin requirements are ignored

* Interest rate is constant. Individuals may borrow or lend as much as they wish at this

rate.

* No dividends

Explanatory Notes:

We may question the utility of a method which assumes only two possible outcomes, but in

reality, security prices do have a “tick size” for each movement, and the period can be

shortened at will. Now it makes sense.

Page 4 of 16
Risk Neutral: ([Link]

“To illustrate, suppose Mary owes Joe $100. She says to him, "I'd be happy to pay you the $100 right

now. Alternatively, you can flip a coin. If it comes up heads, I will pay you $200 right now. If it comes

up tails, I will pay you nothing. Which do you want?" If Joe answers, "I don't care," he is risk-neutral.

If he prefers the first option, he is risk-averse. If he prefers the second, he likes to gamble”

How it works

A replicating portfolio uses a combination of risk-free borrowing/lending and the underlying

asset to create a portfolio that has the same cash flows as the option being valued. The

principles of arbitrage apply here and the value of the option must be equal to the value of the

replicating portfolio.(Ionization et al., n.d.)

Call Option

S = 40

K = 45

u = 25%

d = -10%

r = 5%

Page 5 of 16
 Su 50
Cu 5
K 45
S 40
c ?

Sd 36
Cd 0

T=0 T=1

(Su = 50, call is in the money, value 5.

Sd = 36, call is out of the money, value 0)

S = spot price

K = strike price

u = % increase in price over 1 period

d = % decrease in price over 1 period

Su= price uptick, at end of 1 period (40*1.25=50)

Sd= price downtick, at end of 1 period (40*0.9=36)

r = risk-free rate of interest4

c = value (premium) of the call option at time 0

Cu = Value of Call at end of 1 period, if spot price is Su

4
For no arbitrage, it is essential that u > r > d

Page 6 of 16
Cd = Value of Call at end of 1 period, if spot price is Sd

The Replicating Portfolio Approach

Buy  shares of stock and borrow an amount B. This should have the same value as holding

the call (else, there would be an arbitrage opportunity)

(Delta?  (Delta) is the riskless hedge ratio; 0 < c < 1

It is the number of shares purchased to hedge one call sold. Put differently, it is the

sensitivity of the change in price of the call option, to change in the price of the underlying.)

Replicating Portfolio continued:

The value of this portfolio in the two states would be

Up (1+u)S0 + (1+r)B = Cu

Down (1+d)S0 + (1+r)B = C

d

C u  Cd Cu  Cd
Δ  Eq. 1
(u  d)S S u  Sd

= (5 – 0) = 5/14 = 0.357143

(50 -36)

* This is also called the Hedge Ratio and it is the sensitivity of the change in option price

w.r.t. change in price of the underlying (option Delta)5

5
The delta changes as the parameters driving it change

Page 7 of 16
 (1  u)Cd  (1  d)Cu
B Eq. 2
(u  d)(1  r)

= -12.2449 (discrete discounting)

This is the amount borrowed, on which interest must be paid.

Value of the call today, c= S + B = (.357143 * 40) -12.2449 = 2.0408 6

“….all we needed to determine the exact value of the call was its striking price, underlying

stock price, range of movement in the underlying stock price, and the rate of interest. What

may seem more incredible is what we do not need to know: among other things, we do not

need to know the probability that the stock price will rise or fall. Bulls and bears must agree

on the value of the call, relative to its underlying stock price!” (Cox et al., 1979)

The Risk Neutral Approach:

We can determine the probability of an up-move

p= r–d Eq. 3

u–d

and the probability of a down-move

1-p, or u–r Eq. 4

u–d

6
Discrete discounting is used here, usually, continuous discounting will be used

Page 8 of 16
The value of the call is:

c= [pCu + (1-p)Cd] Eq. 5

(1+r)

i.e. expected value of the Call at the end of the period is

probability of up-move * value of call given up-move + probability of down-move * value of

call given down-move

This is discounted at the risk-free rate to arrive at the present value of this call option.

It should be exactly the same as the value calculated above.

Solving,

p= r–d (0.05-(-0.1))/(0.25-(-0.1))
u–d

p= 0.428571
1-p = 0.571429

c= [pCu + (1-p)Cd]
(1+r)
(0.428571*5+0.571429*0)/(1.05)
c= 2.0408

Risk Neutral World: all assets are priced such that the return equals “r”, the risk-free rate

Page 9 of 16
Proof:

1) In our example, the spot price today of the stock should be equal to the present value

of the discounted expected value at the end of Period 1.

Expected value at end of period 1

State of Nature Probability Price Expected
p 0.428571 50 21.428571
1-p 0.571429 36 20.571429

Expected Price After 1 Period 42.00

Hence, Price Today 40.00
(discounted @ 5% for 1 year)
This is precisely the current market price

2) The value of the portfolio should replicate holding the call, irrespective of the state of

the market.7

Up ∆(1+u)S0 + (1+r)B = Cu 5/14*50+(1.05)*(-12.2449) 5

Down ∆(1+d)S0 + (1+r)B = Cd 5/14*(36)+(1.05)*(-12.2449) 0

Value of call in uptick max (50-45,0) 5

Value of call in downtick max(36-45,0) 0

3) No Arbitrage: (Options, Futures and Other Derivatives, 9th Edition, 2014, John C.

Hull)

Suppose a stock is currently priced at $20

In 3 months, it will be either $22, or $ 18 (either 10% up or 10% down)

7
A fundamental property of assets & options, is that their price cannot be negative

Page 10 of 16
Suppose a 3-month call option on this stock has a strike price of 21

Stock Price = $22

Option Price = $1
Stock price = $20
Option Price=?

Stock Price = $18

Option Price = $0

For a portfolio that is long ∆ shares and short 1 call option, the values are

Page 11 of 16
When the spot price is 22, the call option (21 strike price) is in the money, with value of 1.

Hence, the writer (seller) of the option has a loss of 1. She also holds ∆ shares, hence value

of her portfolio is

22∆ - 1

When the spot price is 18, the call option is out of the money, hence value is 0. She also holds

∆ shares, hence value of her portfolio is

18∆

Please remember, we assumed a risk-neutral world & this was supposed to be a risk-free

portfolio. In effect, no matter what the stock price after 3 months, the portfolio value

should be identical, viz.

22∆ - 1 = 18∆ or, 4∆ = 1

Solving, we find that ∆ = 0.25

Valuing The Portfolio

Risk-free rate 12% (assume)

This (riskless) portfolio is

long 0.25 shares

short 1 call option

a) The value of this portfolio in 3 months is (uptick)

22∆ - 1 = 22 * .25 -1 = 4.50

Page 12 of 16
The value of the portfolio today is 8

4.5e–0.12×0.25 = 4.3670

4.50 is the value after 3 months, this is discounted at the risk free rate (12%) for 3 months

(0.25), using continuous discounting (raised to -.12 because we wish to discount it, not

compound it)

In this portfolio, the value of shares today is 20 * .25 = 5

The portfolio is valued at 4.3670,

Hence the value of the call option today (option premium) must be 5 –

4.3670 = 0.633

b) The value of this portfolio in 3 months is (downtick)

18∆ = 18 * .25 = 4.50

(the portfolio has the same value after three months, whether the stock is up or down)

The value of the portfolio today is

4.5e–0.12×0.25 = 4.3670

In this portfolio, the value of shares today is 20 * .25 = 5

The portfolio is valued at 4.3670,

8
Continuous compounding/discounting

Page 13 of 16
Hence the value of the call option today (option premium) must be 5 –

4.3670 = 0.633

Conclusion

This model can be used for valuing calls, puts & multi-period options. It accepts variations

such as dividend payouts & early exercise (American options). It is easy to understand and

versatile. We shall discuss how the Binomial Option Pricing Model can value variations in a

subsequent article.

Final Thoughts

As T is divided into tiny intervals (becoming a continuum), and given that stock prices follow

the lognormal distribution, the binomial formula converges to the Black-Scholes formula.

(Press, 2008)

Page 14 of 16
Bibliography

Cox, J. C., Ross, S., & Rubinstein, M. (1979). Option pricing: A simplified approach. Journal

of Financial Economics, 7, 229–263. doi:10.1016/0304-405X(79)90015-1

Hull, John C (2014). Options, Futures and Other Derivatives, 9th Edition.

Ionization, D., Spectrometry, T. M., Ramalinga, U., Clogston, J. D., Patri, A. K., & Simpson,

J. T. (n.d.). Chapter 5, 697, 1–31. doi:10.1007/978-1-60327-198-1

Press, C. (2008). The Pricing of Options and Corporate Liabilities Author ( s ): Fischer Black

and Myron Scholes Source : The Journal of Political Economy , Vol . 81 , No . 3 ( May -

Jun ., 1973 ), pp . 637-654 Published by : The University of Chicago Press Stable URL :

ht, 81(3), 637–654.

Websites

[Link]

Page 15 of 16
e&oe. Without prejudice, without recourse

Manohar V Dansingani

91 9225512580

mdansingani@[Link]

Page 16 of 16