FIN4110: Options and Futures

Zongbo Huang
CUHK(SZ)
One-Period Binomial Models
Binomial Assumptions for Stock Prices

1
• To derive an exact pricing formula for options, we need to
specify a specific random process for the underlying stock
prices. Binomial models use the most basic structure.
• Over each period in time, the stock price can move from S to
either uS or dS.
uS
S

dS

• Suppose the length of a period is h and R = erh . To avoid

arbitrage,
u > R > d.
• Although the tree looks simple, with enough periods, it is a good
approximation of the reality.

1
An Example

• Suppose that S = 50, u = 2, d = 0.5 and R = 1.25.

100
50

25

• What is the value of a European call option with K = 50 one

period prior to expiration?

2
An Example

• Suppose that S = 50, u = 2, d = 0.5 and R = 1.25.

100
50

1 25

• What is the value of a European call option with K = 50 one

period prior to expiration?
• The payoff of the option is
50
C?

• Like cash-carry
0 trades, can we replicate this payoff using stock
and bond?

2
Replicating Strategy

• Construct the following replicating portfolio: long ∆ shares of

the stock and B dollars of bond.

3
Replicating Strategy
1
• Construct the following replicating portfolio: long ∆ shares of
the stock and B dollars of bond.
• The payoff from the portfolio:
ΔuS+RB=100Δ+1.25B
ΔS+B=50Δ+B

ΔdS+RB=25Δ+1.25B

0 3
Replicating Strategy
1
• Construct the following replicating portfolio: long ∆ shares of
the stock and B dollars of bond.
• The payoff from the portfolio:
ΔuS+RB=100Δ+1.25B
ΔS+B=50Δ+B

ΔdS+RB=25Δ+1.25B

• Denote Cu as the option payoff in the up state and Cd as the

option payoff in the down state.
• To match the option payoff, we choose ∆ and B such that

Cu = ∆uS + RB
Cd = ∆dS + RB

0 3
• Solving these equations provides
Cu − Cd
∆ =
S(u − d)
uCd − dCu
B =
R(u − d)

• ∆ is ratio between the difference in the option payoff across the

up and down states and the difference in the stock payoff.

4
• Solving these equations provides
Cu − Cd
∆ =
S(u − d)
uCd − dCu
B =
R(u − d)

• ∆ is ratio between the difference in the option payoff across the

up and down states and the difference in the stock payoff.
• Example: S = 50, K = 50, u = 2, d = 0.5, and R = 1.25. Therefore,
50
∆= = 2/3,
100 − 25
and
B = −13.33
Finally, the option value is

C = ∆S + B = 20.

4
An NPV Formula for Option Prices

• By substituting in ∆ and B into C, we obtain

Cu − Cd uCd − dCu
C= S+
S(u − d) R(u − d)

• Rearranging terms:
[ ]
1 R−d u−R
C= Cu + Cd
R u−d u−d

5
An NPV Formula for Option Prices

• By substituting in ∆ and B into C, we obtain

Cu − Cd uCd − dCu
C= S+
S(u − d) R(u − d)

• Rearranging terms:
[ ]
1 R−d u−R
C= Cu + Cd
R u−d u−d
R−d u−R
• Define p = u−d , then 1 − p = u−d . And we can rewrite C as

1
C= [pCu + (1 − p)Cd ] .
R

5
Comments on the Option Pricing Formula

• The option pricing formula does not require that we know

anything about
1. investor’s attitudes toward risk
or
2. how likely the stock price will move to uS or dS
Does this mean that changes in investors’ attitude toward risk or
changes in investors’ feeling about the prospects for a stock are
not reflected in the option price?

6
How to Interpret ∆?

7
How to Interpret ∆?

• Recall that C = ∆S + B. Thus, ∆ gives the sensitivity of the call

price to a change in the stock price.
• Equivalently, it tells us how you can hedge the risk:
• To hedge a long position in the call, short ∆ shares of the stock.

7
How to Interpret p?

8
How to Interpret p?

• p is equal to the probability the stock goes to uS in a world

where everyone is risk neutral.

8
How to Interpret p?

• p is equal to the probability the stock goes to uS in a world

where everyone is risk neutral.
• If everyone is risk neutral, no asset would earn a return for risk
since no one cares about risk. Then, what is the probability the
stock goes to uS to justify the current stock price S?

8
How to Interpret p?

• p is equal to the probability the stock goes to uS in a world

where everyone is risk neutral.
• If everyone is risk neutral, no asset would earn a return for risk
since no one cares about risk. Then, what is the probability the
stock goes to uS to justify the current stock price S?
• Assume the probability is q. NPV formula implies
1
S= [quS + (1 − q)dS].
R
Solving this equation gives

R−d
q= = p.
u−d

8
• Given that we do not live in a risk neutral world, why is this of
interest?

9
• Given that we do not live in a risk neutral world, why is this of
interest?
• This is of interest because we can use the stock return distribution
in this hypothetical world to price options in a “risk neutral” way,
i.e., the option price equals the discounted expected value of the
payoffs at expiration discounted at the risk free rate.
• This NPV formula is consistent with the no arbitrage principle.

9
Two-Period Binomial Models
A Two-Period Binomial Tree

u2S

uS

S
udS

dS

d2S

Each period, the stock price goes up to a multiple of u, or goes down

to a multiple of d.

10
 1
An Example

• S = 50, u = 2, d = 0.5, and R = 1.25.

200

100

50
50

25

12.5

• What is the payoff of a European call with K = 50?

11
 1
An Example

• S = 50, u = 2, d = 0.5, and R = 1.25.

200

100

50
50

1 25

12.5

• What is the payoff of a European call with K = 50?

150

Cu

C
0

Cd

0
0

11
• If you are one period from expiration and the stock price is uS.
The problem looks like
Stock Price Option Price

200
150

100
Cu

50
0

12
• If you are one period from expiration and the stock price is uS.
The problem looks like
Stock Price Option Price

200
150

100
Cu

50
0

• This is just a one-period problem which we know how to solve.

In particular,
pCuu + (1 − p)Cud 0.5 × 150 + 0.5 × 0
Cu = = = 60.
R 1.25
• Recall that this formula comes from replicating the option
payoff using stock and bond:
Cu = ∆u Su + Bu
where
150 − 0
∆u = = 1, Bu = −40.
200 − 50
12
• If you are one period from expiration and the stock price is dS.
The problem looks like
Stock Price Option Price

50
0

25
Cd

12.5
0

13
• If you are one period from expiration and the stock price is dS.
The problem looks like
Stock Price Option Price

50
0

25
Cd

12.5
0

• Then,
pCud + (1 − p)Cdd
Cd = = 0.
R
• This formula comes from replicating the option payoff using
stock and bond:
Cd = ∆d Sd + Bd
where
∆d = 0, Bu = 0.

13
• If you are two periods from expiration. The problem looks like
Stock Price Option Price

100
Cu=60

50
C

25
Cd=0

14
• If you are two periods from expiration. The problem looks like
Stock Price Option Price

100
Cu=60

50
C

25
Cd=0

• Then,
pCu + (1 − p)Cd 0.5 × 60 + 0.5 × 0
C= = = 24.
R 1.25
• This formula comes from replicating the option payoff using
stock and bond:
C = ∆S + B
where
Cu − Cd 60 uCd − dCu
∆= = = 0.8, B= = −16.
uS − dS 100 − 25 R(u − d)

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1
General Formulas for Two-Period Tree

Cuu

Cu=[pCuu+(1−p)Cud]/R

2
Δu=(Cuu−Cud)/(u S−udS)
C=[pCu+(1−p)Cd]/R
=[p2C +2p(1−p)C +(1−p)2C ]/R2 Bu=Cu−ΔuuS
uu ud dd

Δ=(Cu−Cd)/(uS−dS)
Cud

B=C−ΔS
C =[pC +(1−p)C ]/R
d ud dd

2
Δd=(Cud−Cdd)/(udS−d S)

Bd=Cd−ΔddS

Cdd

• These formulas allow us to dynamically create a synthetic

option using a portfolio of stock and bond.
• We have to change the portfolio as the stock price moves on the
tree.
0 15
Arbitraging Mispriced Options
Arbitraging Mispriced Options

• Consider a three-period tree with the following parameters:

S = 80, K = 80, u = 1.5, d = 0.5, and R = 1.1.
R−d
• This implies that p = u−d = 0.6.
• We can dynamically create a synthetic option to replicate this
option. The cost is $34.08.
• If the call is selling for $36, how to arbitrage?

16
Arbitraging Mispriced Options

• Consider a three-period tree with the following parameters:

S = 80, K = 80, u = 1.5, d = 0.5, and R = 1.1.
R−d
• This implies that p = u−d = 0.6.
• We can dynamically create a synthetic option to replicate this
option. The cost is $34.08.
• If the call is selling for $36, how to arbitrage?
1. Sell the real call
2. Buy the synthetic call
• What do you get up front?

16
Arbitraging Mispriced Options

• Consider a three-period tree with the following parameters:

S = 80, K = 80, u = 1.5, d = 0.5, and R = 1.1.
R−d
• This implies that p = u−d = 0.6.
• We can dynamically create a synthetic option to replicate this
option. The cost is $34.08.
• If the call is selling for $36, how to arbitrage?
1. Sell the real call
2. Buy the synthetic call
• What do you get up front?

C − ∆S + B = 36 − 34.08 = 1.92.

16
• Suppose that the stock price is 120 two periods prior to option
expiration. If you close your position at that point, what will you
get in the following scenarios:

17
• Suppose that the stock price is 120 two periods prior to option
expiration. If you close your position at that point, what will you
get in the following scenarios:
• If the call price equals the “theoretical value”, $60.50, what is the
payoff from closing your position?

17
• Suppose that the stock price is 120 two periods prior to option
expiration. If you close your position at that point, what will you
get in the following scenarios:
• If the call price equals the “theoretical value”, $60.50, what is the
payoff from closing your position?
• If the call price is less than 60.50, closing the position yield more
than zero since it is cheaper to buy back the call.

17
• Suppose that the stock price is 120 two periods prior to option
expiration. If you close your position at that point, what will you
get in the following scenarios:
• If the call price equals the “theoretical value”, $60.50, what is the
payoff from closing your position?
• If the call price is less than 60.50, closing the position yield more
than zero since it is cheaper to buy back the call.
• If the call price is more than 60.50, closing out the position will
yield less than zero! What should we do now?

17
Options on Dividend Paying
Stocks
A Dividend Paying Stocks
1

• Consider a stock with continuous dividend yield of δ.

• Suppose that the stock price behaves in the usual way:
uS
S

dS

where u and d are ex-dividend stock price movements.

• If we invest the dividend to buy more shares, then 1 share will
grow into θ = eδh shares after one period.
• How to create a synthetic option?

18
A Dividend Paying Stocks

• Payoffs of a call option and a synthetic call:

Option Price Synthetic Call (Δ Shares and $B in Bonds)

Cu=max(uS−K,0)
ΔθuS+RB

C ΔS+B

C =max(dS−K,0)
d
ΔθdS+RB

• Note that you have ∆ shares, this position grows into ∆θ shares
because of the dividend.

19
• By matching the payoffs across the up and down states, we have

Cu − Cd uCd − dCu
∆= , B=
θS(u − d) R(u − d)

Furthermore,

pdiv Cu + (1 − pdiv )Cd

C = ∆S + B = .
R
where
R/θ − d
pdiv = .
u−d
• The formulas are the same as those for non-dividend paying
stocks, except the adjustment in ∆ and the risk-neutral
probability pdiv .

20
American Options on Dividend Paying Stocks

• For an American option, you have the choice to exercise at any

node on the tree. How do you decide?

21
American Options on Dividend Paying Stocks

• For an American option, you have the choice to exercise at any

node on the tree. How do you decide?
• Exercise if the continuation value is less than the immediate
exercise payoff.

21
American Options on Dividend Paying Stocks

• For an American option, you have the choice to exercise at any

node on the tree. How do you decide?
• Exercise if the continuation value is less than the immediate
exercise payoff.
• An example: S = 45, u = 1.2, d = 1/1.2, θ = 1.03, and R = 1.025.
Consider an American call option with K = 40.

21
Options on Currencies
Options on Currencies

1
• Let S be the price of the currency in dollars, i.e., $1.73 per British
pound.
• Let Rf = erf h be the per period gross foreign risk-free rate.
• Let Rd = erh be the per period gross domestic risk-free rate.
• Suppose that the currency price behaves in the usual way:
uS
S

dS

• The foreign interest rate acts like a dividend yield. If we start

with ∆ units of the currency, we will have Rf ∆ units one period
later.
• How to create a synthetic option?

22
• Payoffs of a call option and a synthetic call:
Currency Synthetic Call (Δ in foreign and $B in domestic
option bonds)
Cu=max(uS−K,0)
ΔRfuS+RdB

C ΔS+B

C =max(dS−K,0)
d
ΔR dS+R B
f d

• Note that you have ∆ units of foreign currency, this position

grows into ∆Rf units because of the interest.

23
• By matching the payoffs across the up and down states, we have

Cu − Cd uCd − dCu
∆= , B=
Rf S(u − d) Rd (u − d)

Furthermore,

pcurr Cu + (1 − pcurr )Cd

C = ∆S + B = .
Rd

where
Rd /Rf − d
pcurr = .
u−d
• The formulas are similar to those for dividend paying stocks,
with Rf replacing θ.

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Options on Futures
Options on Futures
1

• Suppose that the futures price behaves in the following way:

uF
F

dF

• To price an option on the futures price, we replicate the payoff

using the future and bond:
Option Price Synthetic Call (Δ Futures and $B in
Bonds)
Cu=max(uF−K,0)
Δ(uF−F)+RB

0
C B

Cd=max(dF−K,0)
Δ(dF−F)+RB

Note that the payoff from one futures at expiration is uF − F or

dF − F, instead of uS or dS for the stock option case.

25
• By matching the payoffs across the up and down states, we have

Cu − Cd (1 − d)Cu + (u − 1)Cd
∆= , B=
F(u − d) R(u − d)

Furthermore,

pfuture Cu + (1 − pfuture )Cd

C=B= .
R
where
1−d
pfuture = .
u−d
• The formulas are similar to those for dividend paying stocks,
with θ = R.

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