Scribd
Upload
35 views3 pages

Tutorial 11 Binomial Option Pricing

The binomial option pricing model values options using a discrete-time framework where the underlying asset can move to one of two possible prices in each period, determined by up and down factors applied to the current price. Rather than probabilities, the up and down factors reflect possible future prices and implied volatility. The value of the option is calculated as the probability-weighted average of the intrinsic values at expiration.

Uploaded by

Henry Ng Yong Kang
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
35 views3 pages

Tutorial 11 Binomial Option Pricing

The binomial option pricing model values options using a discrete-time framework where the underlying asset can move to one of two possible prices in each period, determined by up and down factors applied to the current price. Rather than probabilities, the up and down factors reflect possible future prices and implied volatility. The value of the option is calculated as the probability-weighted average of the intrinsic values at expiration.

Uploaded by

Henry Ng Yong Kang
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 3

Binomial Option Pricing

• Conditions and assumptions


• One period, two outcomes (states) S0U (fu)
• S = current stock price
• u = 1 + return if stock goes up S0d (fd)
• d = 1 + return if stock goes down
• r = risk-free rate
• Value of European call at expiration one period later
• C = Max(0, Su − X) or
u
• C = Max(0, Sd − X)
d
Q1: Why are the probabilities of stock price movements not used in the model for calculating an

option’s price? What variables are used?

ANS: The variables that are used to price the option are: the current stock price, the exercise price,
the risk-free rate, and the parameters u and d, which define the possible future stock prices at
expiration.

Q.2 How is the volatility of the underlying stock reflected in the binomial model?

ANS: The up and down factors reflect a spread between the next two possible stock prices. That
spread is an indication of the volatility. It is easy to see that if we increase u and/or decrease d, we
increase the volatility.
Q.3 Consider a stock worth $25 that can go up or down by 15 percent per period. The risk-free rate
is 10 percent. Use one binomial period.

a. Determine the two possible stock prices for the next period.
b. Determine the intrinsic values at expiration of a European call option with an exercise price of
$25.
c. Find the value of the option today.
d. Construct a hedge by combining a position in stock with a position in the call. Show that the
return on the hedge is the risk-free rate regardless of the outcome, assuming that the call sells for
the value you obtained in part c.

ANS:

a. Cu = 25(1.15) = 28.75 Cd = 25(0.85) = 21.25

b. Max(0, 28.75 – 25) = 3.75

Max(0, 21.25 – 25) = 0

c. Value of the option

p = (1.10 – 0.85)/(1.15 – 0.85) = 0.8333, 1 – p = 0.1667

(0 .8333 )3. 75+( 0. 1667 )0


C= =2. 84
1 .10

d. h = (3.75 – 0.0)/(28.75 – 21.25) = 0.50

Buy 500 shares and write 1000 calls

Q.4: Consider a stock currently priced at $80. In the next period, the stock can either increase by

30 percent or decrease by 15 percent. Assume a call option with an exercise price of $80 and a

risk-free rate of 6 percent. Suppose the call option is currently trading at $12. If the option is

mispriced, what amount of riskless return can be earned using a riskless hedge?

Find the theoretical fair value of the option: The values of Cu and Cd are:

Cu = Max(0, uS – X)
Cu = Max[0, 1.30(80) – 80]
Cu = 24
Cd = Max(0, dS – X)
Cd = Max[0, 0.85(80) – 80]
Cd = 0
p is the probability that gives a return on the stock equal to the risk-free rate:

The hedge ratio, p value, and theoretical fair value of the call are:

h = (24 – 0)/(104 – 68) = 0.667

p = (1 + 0.06 – 0.85)/(1.30 – 0.85) = 0.467

Value of the Option (c ) = (0.467(24) + 0(0.533))/1.06 = 10.574

Given that the option is currently trading at $12, the call option is overpriced. Therefore, an opportunity to
capture a riskless return via a riskless hedge exists. We buy 667 shares and write 1,000 calls, the value of the
investment then is:

667($80) – 1,000($12) = $41,360

If the stock decreases to $68, the call would be worthless and the hedge portfolio would be worth 667($68) =
$45,356.

You might also like

pFad - Phonifier reborn

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.

Note: This service is not intended for secure transactions such as banking, social media, email, or purchasing. Use at your own risk. We assume no liability whatsoever for broken pages.


Alternative Proxies:

Alternative Proxy

pFad Proxy

pFad v3 Proxy

pFad v4 Proxy