The Binomial Option Pricing Model

Recap of Futures Pricing

• Futures and forward contracts were fairly
easy to value.
• All that we had to do was to identify a
relationship that would preclude both cash
and carry as well as reverse cash and carry
arbitrage.
 Recap (Cont…)
• The ease of this result was due to the fact
that a futures/forward contract imposes an
obligation on both the parties to the
agreement.
• Options however are relatively more
complex.
• This is because one party has a right while
the other party has an obligation.
 Recap (Cont…)
• Thus as far as the holder of the option is
concerned, he may or may not choose to
exercise his right.
• In the case of European options, the
decision to exercise would depend on
whether ST > X in the case of calls, or
whether ST < X in the case of puts.
 Recap (Cont…)
• Consequently we are concerned with the
odds of exercise and the expected payoff at
expiration.
• For American options the issue is even
more complex, for the holder has the right
to exercise at any point in time.
 Recap (Cont…)
• Consequently, for options, it matters not
only as to where the stock price is currently,
but also as to how it is expected to evolve.
• Hence, in order to value an option, we have
to postulate a process for the price of the
underlying asset.
• The eventual pricing formula is a function
of the process that is assumed.
 Recap (Cont…)
• Some processes will lead to precise
mathematical solutions.
• These are called closed-form solutions.
• In other cases, all that we will get is a
partial differential equation, which has to be
solved by numerical approximation
techniques.
 The Binomial Model
• The first model that we will study is called
the Binomial Option Pricing Model
(BOPM).
• This model assumes that given a value for
the stock price, at the end of the next
period, the price can either be up by X% or
down by Y%.
 Binomial Model (Cont…)
• Since the stock price can take on only one
of two possible prices subsequently, the
name Binomial is used to describe the
process.
• We will first study the model using a single
time period.
• That is, we will assume that we are at time
T-1, and that the option will expire at T.
 The One Period Model
• Let the current stock price be S0.
• At the end of the period, the price S T can be
The One Period Model (Cont…)
 One Period (Cont…)
• Y in this case is obviously a negative
number.
• The stock price tree may be depicted as
follows.
The Stock Price Tree
 Binomial Model (Cont…)
• Now consider a European call option.
• We will denote the exercise price by E,
since X has already been used to denote an
up movement for the stock price.
• In the case of the Binomial model, we
always start with the expiration time of the
option, since the payoffs at expiration are
readily identifiable.
 Binomial (Cont…)
• We will then work backwards.
• Let us denote the call value if the upper
stock price is reached by Cu, and the call
value if the lower stock price is reached by
Cd.
• Cu = Max[0, uS0 – E]
• Cd = Max[0, dS0 – E]
 Binomial (Cont…)
• Our objective is to find that value of the call
option one period earlier, that is right now.
• We will denote this unknown value by C 0.
 A Risk-less Portfolio
• In order to price the option, we will
consider the following investment strategy.
• Let us buy  shares of stock and write one
call option.
• The current value of this portfolio is:
• S0 – C0.
• The negative sign in front of the option
value indicates a short position.
 Risk-less Portfolio (Cont…)
• In the up state, the portfolio will have a
value of: uS0 – Cu
• In the down state, the portfolio will have a
value of: dS0 – Cd
• Suppose we were to select  in such a way
that the value of this portfolio is the same in
both the up as well as the down state?
 Risk-less Portfolio (Cont…)

• Then this portfolio may be said to be risk-

less since there are only two possible states
of nature in the next period.
• So if: uS0 – Cu = dS0 – Cd
 Risk-less Portfolio (Cont…)
•  is known as the hedge ratio.
• Since the portfolio is risk-less it must earn
the risk-less rate of return.
• Let us define r as 1 + risk-less rate.
• If so:
• uS0 – Cu = dS0 – Cd = (S0 – C0)r
 Risk-less Portfolio (Cont…)
• Substituting for , we get:
 The Option Premium
• Let us denote (r-d)/(u-d) by p.
• Therefore, (u-r)/(u-d) = 1-p.
• We can then write C0 as:
 The Option Premium (Cont…)
• This is the one period binomial option
pricing formula.
• p is known as the Risk Neutral probability.
 Parameters
• We have assumed that r, u, and d are
constant.
• This is not a necessary condition.
• That is
– The interest rate may vary from period to
period
– And the magnitude of price moves may also
differ from period to period.
 Numerical Illustration
• Let the current stock price be 100 and the
exercise price of a call option be 100.
• Let there be a possibility of a 20% up move
in the next period and a 20% down move in
the next period.
• Let the risk-less rate be 5% per period.
• Therefore r = 1.05.
 Illustration (Cont…)
• p = (1.05 - .8)/(1.2-.8) = .625
• 1-p = .375
• Cu = Max[0, 120 – 100] = 20
• Cd = Max[0, 80 – 100] = 0
• C0 = .625x20 + .375x0
------------------------------------ = 11.9048
1.05
 The Two-Period Situation
• Now let us extend the model to a case
where there are two periods to expiration.
• That is, the option expires at T, whereas we
are standing at T-2.
• We will denote the current stock price by S 0
• The stock price tree can be depicted as
follows.
 The Stock Price Tree
uuS0
uS0

S0 udS0

dS0 ddS0

T-2 T-1 T
 Two Periods (Cont…)
• Once again, we know the payoff from the
option at expiration.
• Let us go back one period, that is to time T-1.
• At this point in time the problem is essentially
a one-period problem, to which we have a
solution already.
 Two Periods (Cont…)
• Let us denote the option premia
corresponding to values of the stock at time
T, as Cuu, Cud, and Cdd.
• If so, then:
 Two Periods (Cont…)
• Knowing Cu and Cd, we can work
backwards to get C0, using an iterative
process.
• This procedure can be extended to any
number of periods.
 Numerical Illustration
• Let the current stock price be 100.
• Consider a call option with two periods to
expiration and an exercise price of 100.
• Assume that given a stock price, the price
next period can be 20% more or 20% less.
• Let the risk-less rate of interest be 5%.
• The stock price tree will look as follows.
 The Stock Price Tree
144
120

100 96

80 64

T-2 T-1 T
 Illustration (Cont…)
• p = 0.625 and 1-p = .375.
• Cuu = Max[0, 144- 100] = 44
• Cud = Max[0, 96-100] = 0
• Cdd = Max[0,64-100] = 0
Illustration (Cont…)
 Impact of Time to Expiration
• As you can see, the value of a two period
call is greater than that of a one period call.
• Obviously, because European call options
always have a non-negative time value.
 Pricing European Puts
• We will illustrate the procedure for the one
period case.
• The procedure is similar to the one used for
call options.
• It can easily be extended to the multi-period
case.
 European Puts (Cont…)
• Assume that we have a stock with a price of
S0, which can either go up to uS0 or go
down to dS0.
• Consider a one-period put option with an
exercise price of E.
• Pu = Max[0, E – uS0]
• Pd = Max[0, E – dS0]
 European Puts (Cont…)
• Using similar arguments, we can show that:

and
 European Puts (Cont…)
• p and 1-p, have the same definitions as
before.
 Numerical Illustration
• We will use the same data as before.
• That is: S0 = E = 100
• u = 1.20; d = 0.80; r = 1.05
• Pu = Max[0, 100 – 120] = 0
• Pd = Max[0,100 – 80] = 20
Illustration (Cont…)
 Extension to the Multiperiod
Case
• In the case of a call option with N periods
left to expiration:
 Options on Dividend Paying
Stocks
• Whenever a stock pays dividends,
theoretically, the share price should decline
by the amount of the dividend.
• This feature can be inbuilt into the binomial
option pricing model.
• It is critical to know as to when exactly the
dividend will be paid.
 Dividends (Cont…)
• Let the stock price be 100, and let there be a
possibility of a 20% increase or a 20%
decline every period.
• Let the risk-less rate of return be 5% per
period.
• Consider a European call option with three
periods to expiration.
 Dividends (Cont…)
• The interesting feature is that the stock will
pay a dividend of Rs 16 with one period
remaining to expiration.
• That is, if the option expires at T, then at
T-1, the stock will trade ex-dividend.
• What this means is that the dividend is paid
an instant before the stock trades at T-1.
 Dividends (Cont…)
• In other words, the observable price at T-1,
is post-dividend.
• The stock price tree may be modeled as
follows.
 The Stock Price Tree
153.6

144 128
102.4
120
96
100 96 80
64
57.6
80 64 48

38.4

T-3 T-2 T-1 T

 Dividends (Cont…)
• Notice that because of the dividend, you get
additional branches at time T.
Dividends (Cont…)
 Dividends (Cont…)

• Using these values, we can work backwards

to T-2.
 Dividends (Cont…)
• Working backwards once again:
 American Options
• Now let us extend the model to the pricing
of American calls.
• We will apply the valuation method to the
case of the stock paying dividends.
• The stock price tree will be as depicted
earlier.
 American Options (Cont…)
• The major difference, is that, at each node
of the tree, we have to consider as to
whether the option will be exercised (killed)
or kept alive.
• In other words, we must compare the payoff
from exercising the option, to the price
given by the model if the option is kept
alive.
 American Options (Cont…)
• Let us go back to time T-1.
• Cuu,T-1 = 32.7619
• If the option is exercised the payoff will be 128 –
100 = 28, which is less.
• So the option will not be exercised early.
• Cud,T-1 = Cdd,T-1 = 0
• Since the option is out of the money in either case,
there is no question of early exercise.
 American Options (Cont…)
• Now let us go to T-2.
• Cu,T-2 = 19.5011
• If exercised early, the payoff = 120 –100 =
20.
• So the option will be exercised early.
• Cd,T-2 = 0.
• Since the option is out of the money, there
is no question of early exercise.
 American Options (Cont…)
• If we find that at a particular node, the
option will be exercised early, then we
should take the payoff from early exercise
while working backwards to the previous
node, and not the value given by the model.
 American Options (Cont…)
• Therefore at T-3, the option value will be
calculated as:
 American Options (Cont…)
• Once again you have to check for early
exercise.
• At T-3, the payoff if exercised is
100 –100 = 0, and so there is no question of
early exercise.
 American Options (Cont…)
• Thus the option value is 11.9048.
• The option is more valuable than the
corresponding European call, which was
priced at 11.6078.
• This is because the early exercise option is
clearly valuable in this case.
 European versus American Puts
• We will consider the same data used for the
earlier example.
• That is, the current stock price is equal to
the exercise price is equal to 100.
• Every period the stock price can increase by
20% or decline by 20%.
• The riskless rate is 5%.
• The stock pays no dividends.
 Puts (Cont…)
• Consider puts with 3 periods to expiration.
• The stock price tree can be expressed as
follows.
 Stock Price Tree
172.8

144
120
115.2
96
100
80
76.8
64
51.2
Valuing a European Put
European Put (Cont…)
 Valuing an American Put
• In this case, at each node, we have to
compare the model value with the intrinsic
value of the option.
• The greater of the two values should be
used for subsequent calculations.
• At uuS0, the model value is zero and so is
the intrinsic value.
 American Puts (Cont…)
• At udS0 the model price is 8.2857 and the
intrinsic value is 4.
• So we will take the model value.
• Thus Pu,T-1 is identical for both European as
well as American puts.
• At ddS0 the model price is 31.2381.
• The intrinsic value is however 36.
 American Puts (Cont…)
• Therefore:
• Pd,T-1 = .625 x 8.2857 + .375 x 36
--------------------------------
1.05

= 17.7891
 American Puts (Cont…)
• At dS0, the intrinsic value is 20, which is
greater than 17.7891.
• Therefore:
P0 = .625 x 2.9592 + .375 x 20
------------------------------- = 8.9043
1.05
 American Puts (Cont…)
• Even at this last stage, the model value must
be compared with the intrinsic value.
• In this case the intrinsic value is zero.
• So the option will be valued at 8.9043.
• Not surprisingly the American put is valued
at a higher premium than the European put.