Binomial Trees

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

2
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

3
Generalization

e rT  d
p
ud

4
p as a Probability
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
S0 u
p ƒu
S0
ƒ
(1– S0 d
p) ƒd

5
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

6
Original Example Revisited
S0u = 22
p ƒu = 1
S0=20
ƒ
( 1 – S0d = 18
p)
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: 0.120.25
e d erT
 0. 9
p   0.6523
ud 1. 1  0. 9

7
Valuing the Option Using Risk-Neutral
Valuation
S0u = 22
23
0.65 ƒu = 1
S0=20
ƒ
0.34 S0d = 18
77
ƒd = 0

The value of the option is

e–0.120.25 (0.65231 + 0.34770)
= 0.633
8
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

9
A Two-Step Example
Figure 13.3, page 303

24.2
22

20 19.8

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

10
 Valuing a Call Option
Figure 13.4, page 303 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

11
A Put Option Example
Figure 13.7, page 306
72
0
60
50 1.4147 48
4.1923 4
40
9.4636 32
20

K = 52, time step =1yr

r = 5%, u =1.32, d = 0.8, p = 0.6282

12
What Happens When the Put
Option is American (Figure 13.8, page 307)
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. 20

This increases the value of

the option from 4.1923 to
5.0894.

13
Choosing u and d
One way of matching the volatility is to set

u  e t

d  1 u  e  t

where  is the volatility andt is the length of

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

14
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

15
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

Options, Futures, and Other Derivatives, 9th Edition, Global Edition, Copyright
© John C. Hull 2018 16
The Probability of an Up Move
ad
p
ud

a  e rt for a nondividend paying stock

a  e ( r  q ) t for a stock index where q is the dividend

yield on the index

( r  r ) t
ae f for a currency where r f is the foreign
risk - free rate

a  1 for a futures contract

Options, Futures, and Other Derivatives, 9th Edition, Global Edition, Copyright
© John C. Hull 2018 17
Proving Black-Scholes-Merton from
Binomial Trees (Appendix to Chapter 13)
n
n!
ce  rT

j  0 ( n  j )! j!
p j (1  p) n  j max(S 0u j d n  j  K , 0)

Option is in the money when j >  where

n ln( S 0 K )
 
2 2 T n
so that
c  e  rT ( S 0U1  KU 2 )
where
n!
U1   p j (1  p ) n  j u j d n  j
j   ( n  j )! j!

n!
U2   p j (1  p ) n  j
j   ( n  j )! j!

Options, Futures, and Other Derivatives, 9th Edition, Global Edition, Copyright
© John C. Hull 2018 18
Proving Black-Scholes-Merton from
Binomial Trees continued
The expression for U1 can be written

U1  [ pu  (1  p )d ]n 
n!
  j
p* 1  p* n j
 e rT 
n!
  j
p* 1  p* 
n j

j   ( n  j )! j! j   ( n  j )! j!

where pu
p* 
pu  (1  p )d

Both U1 and U2 can now be evaluated in terms of the

cumulative binomial distribution
We now let the number of time steps tend to infinity
and use the result that a binomial distribution tends to
a normal distribution
Options, Futures, and Other Derivatives, 9th Edition, Global Edition, Copyright
© John C. Hull 2018 19