09/04/2018

Chapter 13
Binomial Trees

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 1

A Simple Binomial Model

A stock price is currently $20

In 3 months it will be either $22 or $18

Stock Price = $22

Stock price = $20
Stock Price = $18

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A Call Option
A 3-month call option on the stock has a strike
price of 21.

Stock Price = $22

Option Price = $1
Stock price = $20
Option Price=?
Stock Price = $18
Option Price = $0

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 3

Setting Up a Riskless Portfolio

For a portfolio that is long D shares and a short 1 call
option values are
SuT D – CuT = 22D – 1

SdTD – CdT = 18D – 0

Portfolio is riskless when 22D – 1 = 18D or D = 0.25

Notes: SuT = S0u; SdT = S0d

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Valuing the Portfolio

(Risk-Free Rate is 12%)
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
The value of the portfolio today is
4.5e–0.12×0.25 = 4.3670

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 5

Valuing the Option

The portfolio that is
long 0.25 shares
short 1 option
is worth 4.367
The value of the shares is
5.000 (= 0.25 × 20 )
The value of the option is therefore
0.633 ( 5.000 – 0.633 = 4.367 )

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Generalization (Figure 13.2, page 276)

A derivative lasts for time T and is dependent
on a stock
S0u
ƒu
S0
ƒ0
S0d
ƒd
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Generalization (continued)
Value of a portfolio that is long D shares and short 1
derivative: S uD – ƒ 0 u
S0D– f0
S0dD – ƒd

The portfolio is riskless when S0uD – ƒu = S0dD – ƒd or

ƒu  f d
D
S 0u  S 0 d
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Generalization (continued)

Value of the portfolio at time T is S0uD – ƒu

Value of the portfolio today is (S0uD – ƒu)e–rT
Another expression for the portfolio value
today is S0D – f
Hence
ƒ = S0D – (S0uD – ƒu )e–rT

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 9

Generalization
(continued)

Substituting for D we obtain

ƒ = [ pƒu + (1 – p)ƒd ]e–rT

where
e rT  d
p
ud

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p as a Probability
ƒ = [ p ƒu + (1 – p )ƒd ]e-rT
It is natural to interpret p and 1-p as probabilities of up
and down movements
The value of a derivative is then its expected payoff in
a risk-neutral world discounted at the risk-free rate
S0u
ƒu
S0
ƒ
S0d
ƒd
Options, Futures, and Other Derivatives, 9th Edition,
Copyright © John C. Hull 2014 11

Risk-Neutral Valuation
When the probability of an up and down movements
are p and 1-p the expected stock price at time T is
S0erT
This shows that the stock price earns the risk-free
rate
Binomial trees illustrate the general result that to
value a derivative we can assume that the expected
return on the underlying asset is the risk-free rate and
discount at the risk-free rate
This is known as using risk-neutral valuation

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Original Example Revisited

S0u = 22
ƒu = 1
S0=20
ƒ
S0d = 18
ƒd = 0

p is the probability that gives a return on the stock equal to the

risk-free rate:
20e 0.12 ×0.25 = 22p + 18(1 – p ) so that p = 0.6523
Alternatively: 0 .2 5
e d e
rT
 0.9
0 .1 2
p   0.6523
ud 1.1  0.9

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 13

Valuing the Option Using Risk-Neutral

Valuation
S0u = 22
ƒu = 1
S0=20
ƒ
S0d = 18
ƒd = 0

The value of the option is

e–0.12×0.25 (0.6523×1 + 0.3477×0)
= 0.633

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Irrelevance of Stock’s Expected

Return
When we are valuing an option in terms of the price
of the underlying asset, the probability of up and
down movements in the real world are irrelevant
This is an example of a more general result stating
that the expected return on the underlying asset in
the real world is irrelevant

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 15

A Two-Step Example
24.2
22

20 19.8

18
16.2
K=21, r = 12%
Each time step is 3 months

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Valuing a Call Option

24.2
3.2
22
B
20 2.0257 19.8
1.2823 A 0.0
18

0.0 16.2
0.0
Value at node B
= e–0.12×0.25(0.6523×3.2 + 0.3477×0) = 2.0257
Value at node A
= e–0.12×0.25(0.6523×2.0257 + 0.3477×0) = 1.2823
Options, Futures, and Other Derivatives, 9th Edition,
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A Put Option Example

72
0
60
50 1.4147 48
4.1923 4
40
9.4636 32
20

K = 52, time step =1yr

r = 5%, u =1.2, d = 0.8, p = 0.6282

Options, Futures, and Other Derivatives, 9th Edition,

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What Happens When the Put

Option is American
72
0
60

50 1.4147 48
5.0894 4
40
The American feature C
increases the value at node 12.0 32
C from 9.4636 to 12.0000. 9.4636 20

This increases the value of

the option from 4.1923 to
5.0894.
Options, Futures, and Other Derivatives, 9th Edition,
Copyright © John C. Hull 2014 19

Delta
Delta (D) is the ratio of the change in the
price of a stock option to the change in
the price of the underlying stock
The value of D varies from node to node

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Delta – Example revisited

t0 t1 T Prob
24,2000 0,4255
3,2000

22,0000
2,0256
D 0,72727
20,0000 19,8000 0,4536
1,2822 0,0000
D  0,5064
18,0000
0,0000
D  0,0000
16,2000 0,1209
0,0000

1,0000 21

Delta – Example revisited

Consider the Portfolio: long D shares
short 1 call option

The portfolio value at each node is:

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Delta – Example revisited

t0 t1 T
24,2000
t = StDt-ft
3,2000
(#S = D; #f =-1)
  14,4
22,0000
2,0256
 9,1151
  
20,0000 13,9744 19,8000

1,2822 0,0000
  8,8457   14,4
18,0000 0
0,0000
 9,1151
  
 0 16,2000
0,0000
  0
#f -1
#S D 23

Delta – Example revisited

What is the rate of return of the total portfolio?

Interest earned in 3 months

t0 t1 T Rate (3mth) Annual rate

8,8457 9,1151 0,03 0,12

13,9744 14,4000 0,03 0,12

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Generalization Multi-Period
A derivative lasts for time T. Each time step =dt
dt dt
t0 t1 t2 T
S0uu
S 0u ƒuu
S0 n time steps
ƒu S0ud …
ƒ0 =>
ƒud
S 0d n+1 scenarios
ƒd S0dd
ƒdd
25

Generalization Multi-Period
Consider the portfolio that is long D shares and short 1
derivative S uD – ƒ
t t u,t+1

StDt– ft
StdDt – ƒd,t+1

The portfolio is riskless when StuD – ƒu,t+1 = Std D – ƒd,t+1

or ƒ  f
u ,t 1 d ,t 1
Dt 
St u  St d

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Generalization Multi-Period
Value of the portfolio at time t+1 is
Stu Dt – ƒu,t+1
Value of the portfolio at t is
(Stu Dt – ƒu,t+1 )e–r dt
Another expression for the portfolio value at
time t is
S tDt – f t
Hence
ƒt = StDt – (Stu Dt – ƒu,t+1 )e–rdt
27

Choosing u and d
One way of matching the volatility is to set

u  es dt

d  1 u  e s dt

where s is the volatility and Dt is the length of

the time step. This is the approach used by
Cox, Ross, and Rubinstein

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Girsanov’s Theorem
Volatility is the same in the real world and the
risk-neutral world
We can therefore measure volatility in the
real world and use it to build a tree for the an
asset in the risk-neutral world

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 29

Assets Other than Non-Dividend

Paying Stocks
For options on stock indices, currencies and
futures the basic procedure for constructing
the tree is the same except for the calculation
of p

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The Probability of an Up Move

ad
p
ud

a  e rDt for a nondiv iden

d pay ings toc k

a  e ( r  q ) Dt for a s toc kindex w her

e q is the div idend
y ield on the index

( r  r ) Dt
ae f for a c urrenc y here
w r f is the foreign
ris k- free rate

a  1 for a futuresc ontrac t

Options, Futures, and Other Derivatives, 9th Edition,

Copyright © John C. Hull 2014 31

Binomial Distribution
The Pascal's Triangle 1 2 3 4 ...
– number of ways to
1
reach a certain node 1
1 4
1 3
1 2 6 ...
1 3
1 4
1
1

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Binomial Distribution
The Probability of observing two heads in
three flips of a fair coin? (p=0.5; s=2; n=3)

Bs \ n, p   n  ps 1 pns

s 

With  n  n!
s 
  n  s ! s!

33

Binomial Distribution
Gives the Probability of observing a certain
number of successful results (s) on a total
number of attempts (n) having a probability p
of a success, without carrying the order of the
outcome.
Bs \ n, p   n  ps 1 pns
s 
 n  n!
s 
  n  s ! s!
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Binomial Distribution
Expected Value of Binomial Distribution

EBs \ n, p   np

Variance of Binomial Distribution

VarBs \ n, p  np1  p

35

Binomial Distribution
The Probability of observing two heads in
three flips of a fair coin? (p=0.5; s=2; n=3)

B2 \ 3,0.5   3 0.52 1  0.532 

3!
0.53  0.375
 2 3  2!2!

EB2 \ 3,0.5  3x0.5  1.5

VarB2 \ 3,0.5  3x0.51  0.5  0.75

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Binomial Model
The value of a derivative is simply its
expected value at maturity discounted at the
risk free rate (given the risk neutral
argument)

f 0  E  fT e  r

37

Binomial Model
For an European call option



 

c0  E Max 0; u s d n s S0  K  er


For a European put option

 
p0  E Max 0; K  u s d n  s S 0 e  r

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Binomial Model
This is equal to:
A. European Calls

n
c0  
n!
 
p s 1  p  Max 0; u s d n  s S 0  K  e  r
ns

 s 0 n  s ! s! 
B. European Puts
n
p0  
n!
 

p s 1  p  Max 0; K  u s d n  s S 0  e  r
ns

 s 0 n  s ! s! 
We now let the number of time steps tend to infinity and
use the result that a binomial distribution tends to a
normal distribution 39

Example of Binomial Model

What is the value of a European call option
with expiry date within 1 year and exercise
price of 10€ if the stock price is currently at
8€, the risk free interest rate is at 5% annum,
the volatility is at 20%? (Assume that no
dividends are expected until maturity and 3
time steps)

40

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Binomial Model
0 .2 x 1
ue 3  1 .1 2 2 4 0.05 x 1
3  0.8909
e
 0.2 x 1 p  0.5438
d e 3  0.8909 1.1224 0.8909

 3 
0.5438s 1  0.54383 s x
3!
  0.05 x1
c0   3  s ! s!  e
 
s 0
 
 xMax 0;1.124s x0.89093 s x8  10 

41

Binomial Model
 3! 0 3 0

 3  0!0! 0.5438 1  0.5438 xMax 0;1.124 x0.8909 x8  10
0 3 0
 



3!
  
0.543811  0.543831 xMax 0;1.1241 x0.890931 x8  10  
c0   3  1!1!
   0.05 x1

3!
 3  2!2!
2

0.5438 1  0.5438 xMax 0;1.124 x0.8909 x8  10  
3 2 2 3 2


 e

 3  3!3!


 3! 0.54383 1  0.543833 xMax 0;1.1243 x0.890933 x8  10   



c0  0.2006€

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