20-11-2020

Binomial Option Pricing Model

Sankarshan Basu
Professor of Finance
Indian Institute of Management Bangalore

Binomial Tree
• Binomial tree is a diagram representing
different paths that might be followed by the
stock price over the life of an option.
• It is assumed that stock price follows random
walk.
• At each time step, there is certain probability of
moving up or down with certain percentage.
• As time step becomes smaller, this model leads
to lognormal assumption of stock prices.

A Simple Binomial Model

• A stock price is currently Rs.20
• At the end of three months it will be either Rs.22
or Rs.18
• The situation can be represented by the
following diagram:
Stock Price = Rs.22

Stock price = Rs.20

Stock Price = Rs.18

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A Simple Binomial Model – contd.

• A 3-month European call option on the stock
has a strike price of Rs.21.
• The possible values of this call option in three
months time is shown below.
• We need to find the price of option now.
• The situation is represented below:
Stock Price = Rs.22
Option Payoff =
Stock price = Rs.20 Rs.1
Option Price=?
Stock Price = Rs.18
Option Payoff = Rs.0
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A Simple Binomial Model – contd.

• Now we want to set up a riskless portfolio of the
stock and the option to eliminate uncertainty
regarding the value of portfolio at the end of 3
months.
• Consider the Portfolio: long D shares
short 1 call option
• Possible outcomes are shown in the diagram below:

22∆ – 1

18∆
• Portfolio is riskless when 22D – 1 = 18D or D = 0.25
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A Simple Binomial Model – contd.

• The riskless portfolio is:
long 0.25 shares
short 1 call option
• The value of the portfolio in 3 months is
22*0.25 – 1 = 4.50
or, 18*0.25 = 4.50
• If the risk free interest rate is 12% per annum
then the value of the portfolio today is
4.5e – 0.12*0.25 = 4.3670

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Valuing the Option

• Hence, the portfolio that is
long 0.25 shares
short 1 option
is worth 4.367
• The value of the stock price is Rs.20
• Consider the value of option today as c
• Hence the value of the portfolio today
= 20*0.25 – c = 4.367
• The value of the option today is therefore
= c = 5.000 – 4.367 = Rs. 0.633
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Generalization
• Notations:
S0 = Stock price
ƒ = Call option price
T = time of option
S0u= up level for stock price where u > 1
ƒu = payoff from option when stock price rises to S0u
S0d = down level for stock price where d < 1
ƒd = payoff from option when stock price goes down to
S0d

Generalization
• The value of a derivative is its expected payoff in a risk-
neutral world discounted at the risk-free rate

S0u
p ƒu
S0
ƒ S0d
1–p
ƒd
e rT  d
• ƒ = [ pƒu + (1 – p)ƒd ]e–rT where p
ud
• It is natural to interpret p and 1-p as probabilities of up
and down movements.

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Original Example Revisited

S0u = 22
ƒu = 1 Time period 3 months =
S0 0.25 years
ƒ S0d = 18 Risk free interest rate =
ƒd = 0 12% per annum

e rT  d e 0.12*0.25  0.9
p   0.6523
ud 1 .1  0 .9
• Hence the value of the option is
= e–0.12*0.25 (0.6523*1 + 0.3477*0)
= Rs. 0.633

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Calculation of u and d

u  upward movement  es Dt

d  downward movement  1 u  e s Dt

where s is the volatility and Dt is the

length of the time step.

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Pricing European Call Option

(2 steps)
24.2
22

20 19.8

18
16.2
• Each time step is 3 months
• K=21, r=12%, p =0.6523
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Pricing European Call Option

(2 steps) 24.2
D
3.2
22
B
20 2.0257 19.8
A E
1.2823 0.0
18
C
0.0 16.2
F 0.0
• Value at node B
= e–0.12*(3/12)(0.6523*3.2 + 0.3477*0)
= 2.0257
• Value at node A
= e–0.12*(3/12)(0.6523*2.0257 + 0.3477*0)
= 1.2823
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Pricing European Put Option

(2 steps)
K = 52, Each time step = Dt = 1 year, r = 5%
72
D
60
B
50 48
A E
40
C
32
F

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Pricing European Call Option

(2 steps)
• Here fuu = 0; fud = 4 and fdd = 20
• u = 1.2 and d = 0.8
• p = (e0.05*1 – 0.8)/(1.2 – 0.8)
= 0.6282
• Hence f
= e–2*0.05*1 (0.62822*0 +
2*0.6282*0.3718*4 + 0.37182*20)
= 4.1923

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Pricing European Put Option

(2 steps)

72
D
0
60
B
50 1.4147 48
A E 4
4.1923
40
C
9.4636 32
F 20

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Pricing American Put Option

(2 steps)
• At earlier nodes the value of the option is the
greater of
1. The value given by equation
ƒ = [ pƒu + (1 – p)ƒd ]e–rT
2. The payoff from early exercise 72
D 0
60
B
K = 52
50 Max (1.4147, 0) 48
Each time step A E 4
= Dt = 1 year Max (5.0894, 2) 40
C
r = 5%
Max(9.4636, 12.0) 32
F 20
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Valuing Options on Other Assets

• We can use this approach to value options

on stocks paying a continuous dividend
yield, stock indices, currencies and futures
except that the equation for p changes.

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The Probability of an Up Move for

Options on Other Assets
ad
p
ud

a  e rDt for a nondividend paying stock

a  e ( r  q ) Dt for a stock index where q is the dividend
yield on the index
( r  r f ) Dt
ae for a currency where rf is the foreign
risk - free rate
a  1 for a futures contract
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Problem No. 1
• A stock price is currently $50. It is known
that at the end of six months it will be
either $60 or $42. The risk-free rate of
interest with continuous compounding is
12% per annum. Calculate the value of a
six-month European call option on the
stock with an exercise price of $48. Verify
that no-arbitrage arguments and risk-
neutral valuation arguments give the same
answers.
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Problem No. 1 (Ans.)

• The value of the six-month European call
option = 6.96

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Problem No. 1 (Explanation-

No Arbitrage Argument)
• At the end of six months the value of the option will be
either $12 (if the stock price is $60) or $0 (if the stock
price is $42).
• Consider the portfolio consisting of :
+∆ : shares
–1 : option
• The value of the portfolio is either 42∆ or (60∆ – 12) in
six months.
• If 42∆ = 60∆ – 12, then
∆ = 0.6667
• The value of the portfolio is 28.
• For this value of ∆ this portfolio is therefore riskless.

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Problem No. 1 (Explanation-

No Arbitrage Argument)
• The current value of the portfolio is:
0.6667*50 – f
• Where f is the value of the option.
• Since the portfolio must earn the risk-free
rate of interest
(0.6667*50 – f)e0.12*0.5 = 28
or, f = 6.96

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Problem No. 1 (Explanation – Risk-

neutral valuation)
• Suppose that p is the probability of an upward
stock price movement in a risk neutral world.
• Then, p = (e0.12*0.5 – 0.84)/(1.2 – 0.84)
= 0.6161
• The expected value of option in a risk-neutral
world is:
f = e–0.12*0.5 (0.6161*12 + 0.3839*0) = 6.96

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Problem No. 2 (European put)

• A stock price is currently $40. Over each
of the next two three-month periods it is
expected to go up by 10% or down by 10%.
The risk-free interest rate is 12% per
annum with continuous compounding.
What is the value of a six-month European
put option with a strike price of $42?

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Problem No. 2 (European put) (Ans.)

• The value of a six-month European put

option = 2.118

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Problem No. 2 (European put)

(Explanation)
• The risk-neutral probability of an up move, p, is given by
p = (e0.25*0.12 – 0.9)/(1.1 – 0.9) = 0.6523
• Calculating the expected payoff and discounting, we get
the value of the option as
= (2.4*2*0.6523*0.3477 + 9.6*0.34772)*e–0.12*0.5
= 2.118
48.4
D
0.0
44
B
40 0.810 39.6
A E
2.118 2.4
36
C
4.759 32.4
F 9.6

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Problem No. 2 (American put)

• A stock price is currently $40. Over each
of the next two three-month periods it is
expected to go up by 10% or down by 10%.
The risk-free interest rate is 12% per
annum with continuous compounding.
What is the value of a six-month American
put option with a strike price of $42?

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Problem No. 2 (American put) (Ans.)

• The value of the American put option =

2.537

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Problem No. 2 (American put)

(Explanation)
• The value of the American put option is shown in
the tree diagram below.
48.4
D
0.0
44
B
40 0.810 39.6
A E
2.537 2.4
36
C
Max (4.759, 6) 32.4
F 9.6

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Problem No. 3
• A stock price is currently $30. During each
2-month period for the next four months it
is expected to increase by 8% or reduce by
10%. The risk-free interest rate is 5%. Use
a two-step tree to calculate the value of a
derivative that pays off [max(30 — ST, 0]2,
where ST is the stock price in 4 months? If
the derivative is American-style, should it
be exercised early?
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Problem No. 3 (Ans.)

• Value of the European Style derivative =
5.394
• Value of the American Style derivative =
5.394. Should not be exercised early.

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Problem No. 3 (Explanation – European)

• The risk-neutral probability of an up move, p, is given by
p = (e0.05*(2/12) – 0.9)/(1.08 – 0.9) = 0.6020
• Calculating the expected payoff and discounting, we get the value of
the option as
= (0.7056*2*0.6020*0.3980+ 32.49*0.39802)*e–0.5*(4/12)
= 5.394
34.922
D 0.0
32.4
B
30 0.2785 29.160
A E 0.7056
5.394
27
C
13.2449 24.3
F 32.49

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Problem No. 3 (Explanation – American)

34.922
D 0.0
32.4
B
30 0.2785 29.160
A E 0.7056
5.394
27
C
Max (9, 13.2449) 24.3
F 32.49

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