Lecture Notes

in
Financial Economics and
Risk Management

Dr. Mario J. Miranda

Andersons Professor of Agricultural Finance and Risk Management
Department of Agricultural, Environmental, and Development Economics
The Ohio State University

Winter 2008
6 Derivatives

6.1 Introduction

A derivative is a financial instrument whose value is determined by the value

of some basic underlying variable. The underlying variable can be the market
price of a commodity, equity, bond, or foreign currency. The underlying
variable, however, can also be an objectively measured index, such as the
value of the S&P 500 index or the losses experienced by property casualty
insurers in Florida due to major hurricanes.

Derivative contracts include forward contracts, futures contracts, options

contracts, and swaps. Forward contracts, custom option contracts, and swaps
are traded regularly between corporations and their clients in “over-the-
counter” trades involving only the two contracting parties. However, the
bulk of trading in derivatives takes place in the form of standardized futures
and option contracts traded on one of the more than 80 organized exchanges
currently operating worldwide.

The top ten derivative exchanges, in terms of number of contracts traded,

are presented in Table 1. The Korea Exchange, located in Seoul, Korea, is
currently the largest exchange in the world in terms of contract volume. The
overwhelming majority of trades undertaken at the exchange involve Korean
Stock Price Index (KOSPI 200) futures. Eurex, located in Frankfurt, Ger-
many, trades over twenty derivative products, including futures and options
on country-specific equity indices and German government bond rates. The
Chicago Mercantile Exchange trades futures and options on foreign curren-
cies, agricultural products (pork, cattle, butter, milk), equity indices (NAS-
DAQ, S&P 500), U.S. and foreign government bond rates, and weather in-
dices. The Chicago Board of Trade, the world’s oldest derivatives exchange,
trades over 50 futures and options contracts, mostly on agricultural com-
modities (corn, soybeans, soy products, wheat), metals (gold, silver), U.S.
Treasury bond rates, and equity indices (Dow Jones Industrial Average).

Futures contracts were introduced by the Chicago Board of Trade in 1865.

Contract trading was initially limited to agricultural commodities, but was

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Table 1: Top Ten Derivative Exchanges by Volume, in Millions of Contracts
Traded, January-June 2006.

Korea Exchange (Seoul) 1,241

Eurex (Frankfurt) 824
Chicago Mercantile Exchange 705
Chicago Board of Trade 401
Euronext.liffe (London) 387
Chicago Board Options Exchange 338
International Securities Exchange (New York) 300
Mexican Derivatives Exchange (Mexico City) 149
Bovespa (Sao Paulo) 133
Bolsa de Mercadorias & Futuros (Sao Paulo) 132

Source: Futures Industry Association

later expanded to include metals. Contracts on financial instruments such as

currency and currency indexes, equities and equity indexes, and government
interest rates were introduced in the mid 1970s by the Chicago Mercantile
Exchange. Financial derivatives quickly overtook commodities derivatives
in terms of trading volume and now account for over 90% of the contracts
traded worldwide. Global trading volumes by class of derivative are presented
in Table 2.

6.2 Forward Contracts

A forward contract is the simplest example of a derivative. It is an agreement

between two parties to exchange a specified asset (or quantity of a commod-
ity), at a specified future date, at a specified price. In a forward contract,
one party assumes a long position, agreeing to buy the underlying asset. The
other party assumes a short position, agreeing to sell the underlying asset.
The date on which the exchange is to take place is called the delivery date
and the price for which the asset will be exchanged is called the delivery

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Table 2: Global Futures and Options Volume, in Millions of Contracts
Traded, by Sector

Jan-Jun Jan-Jun Percent

Sector 2006 2005 Change

Equity Index 2,252 1,780 27%

Interest Rate 1,637 1,320 24%
Individual Equity 1,463 1,139 29%
Agriculture 205 164 25%
Energy 172 131 31%
Currencies 116 75 55%
Metals 99 72 39%
Other 1 1 16%
Total 5,944 4,681 27%

Source: Futures Industry Association

price.

An example of a forward contract is when a farmer, at planting time,

agrees to deliver a specified quantity of grain at harvest time to a grain
elevator, which in turn agrees to pay the farmer a specified price for the
grain upon delivery. Forward contracts are common among firms of all sizes
that have long-standing working relationships. However, the majority of
forward trades in terms of value take place among large financial institutions
and corporations. Forward contracts are said to be traded over-the-counter,
that is, without the involvement of a third party or an organized exchange.

Forward contracts are settled by delivery on the delivery date. The payoff
from a forward contract at delivery will depend on the spot price of the asset
on the delivery date, that is, the price at which the asset can be purchased
or sold for immediate delivery on that date. The payoffs from long and short
forward positions at delivery, as functions of the spot price on the delivery
date sT and the delivery price K, are illustrated in Figure 17. In general,

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the payoff at delivery from a long forward position is ST − K: if ST > K,
the long investor gains because he is entitled to purchase an asset that is
worth ST at a lower price K; if ST < K, the long investor loses because he
is obligated to purchase an asset that is worth ST at a higher price K. The
payoff at delivery from a short forward position is the exact opposite of that
from a long position. In general, the payoff from a short forward position is
K − ST : if ST > K, the short investor loses because he is obligated to sell
an asset that is worth ST at a lower price K; if ST < K, the short investor
gains because he is entitled to sell an asset that is worth ST at a higher price
K.

Payoff Payoff

0 0
K ST K ST

Short Long

Figure 17: Payoff From Forward Contract

6.3 Spot-Forward Price Relationships

At any point in time, the forward price of an asset for delivery at a future
date is the delivery price at which a forward contract for that delivery date
can be consummated. The forward price of an asset for delivery at a specific
delivery date will vary over time as the delivery date approaches. The delivery
price of any forward contract, however, becomes fixed when the contract is
consummated. Below, we derive some relationships between spot and forward
prices that must hold at any given point in time.

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6.3.1 Commodities

Consider a storable commodity, say, gold. Assume that one ounce of gold
currently trades at a spot price s0 ; one ounce of gold can be stored for a
period of T years at a cost kT ; the forward price of one ounce of gold for
delivery in T years is fT ; and the annual yield on a risk-free bond maturing
in T years is r. Let δ = (1+r)−1 denote the annual discount factor for bonds.

Consider the following three transactions: 1) sell one ounce of gold for-
ward for delivery at time T at the current forward price fT ; 2) buy one ounce
of gold at the current spot price s0 and pay kT to store it for T years with
the intent to deliver the gold under the terms of the forward contract in T
years; and 3) sell a risk-free bond with face value fT that matures in T years.
The net cash flows at time 0 and time T generated by these transactions are:

Cash Flow
Transaction t=0 t=T
1) Sell Gold Forward 0 fT
2) Buy Gold Spot −s0 − kT 0
3) Sell Bond δ T fT −fT
Net δ T fT − s0 − kT 0

These transaction, as a whole, create a portfolio that provides a sure

payoff of zero at time T . In order to avoid arbitrage, the net cash flow from
these transactions at time 0 must be zero, implying

fT = (1 + r)T (s0 + kT ).

In the real world, of course, market imperfections such as transaction

costs, differential borrowing and lending rates, and restrictions on short sell-
ing can limit arbitrage opportunities. Thus, the theoretical relationship be-
tween forward and spot prices will need not be observed exactly by market
prices. The deviations from theory, however, should be relatively small if
markets are efficient and transaction costs are small as a percentage of the
value of the underlying asset.

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6.3.2 Equities

Consider a share of common stock that does not pay dividends. Assume that
one share of stock currently trades at a spot price s0 ; the forward price of
one share of stock for delivery in T years is fT ; and the annual yield on a
risk-free bond maturing in T years is r. Let δ = (1 + r)−1 denote the annual
discount factor for bonds.

Consider the following three transactions: 1) sell one share of stock for-
ward for delivery at time T at the current forward price fT ; 2) buy one share
of stock at the current spot price s0 and hold it for eventual delivery in T
years; and 3) sell a risk-free bond with face value fT that matures in T years.
The net cash flows at time 0 and time T generated by these transactions are:

Cash Flow
Transaction t=0 t=T
1) Sell Stock Forward 0 fT
2) Buy Stock Spot −s0 0
3) Sell Bond δ T fT −fT
Net δ T fT − s0 0

These transaction, as a whole, create a portfolio that provides a sure

payoff of zero at time T . In order to avoid arbitrage, the net cash flow from
these transactions at time 0 must be zero, implying

fT = (1 + r)T s0 .

6.3.3 Currencies

Consider two currencies, dollars ($) and pounds (£). Assume that the current
exchange rate is s0 dollars per pound; the forward price of one pound for
delivery in T years is fT dollars; the annual yield on a risk-free bond maturing
in T years denominated in dollars is r$ ; and the annual yield on a risk-free

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bond maturing in T years denominated in pounds is r£ . Let δ$ = (1 + r$ )−1
and δ£ = (1 + r£ )−1 denote the annual discount factors for dollar bonds and
pound bonds, respectively.

Consider the following four transactions: 1) sell one pound forward for
delivery at time T at the current forward price of fT dollars; 2) exchange
T T
δ£ s0 dollars for δ£ pounds on the spot foreign exchange market; 3) sell a
risk-free bond with face value of fT dollars that matures in T years; and 4)
buy a risk-free bond with face value of 1 pound that matures in T years. The
net cash flows at time 0 and time T associated with these transactions are:

Cash Flow t=0 Cash Flow t=T

Transaction Dollars Pounds Dollars Pounds
Sell Pounds Forward 0 0 fT -1
T T
Buy Pounds Spot −δ£ s0 δ£ 0 0
Sell Dollar Bond δ$T fT 0 −fT 0
T
Buy Pound Bond 0 −δ£ 0 1
Net δ$T fT − δ£
T
s0 0 0 0

These transaction, as a whole, create a portfolio that provides a sure

payoff of zero at time T . In order to avoid arbitrage, the net cash flow from
these transactions at time 0 must be zero, implying

µ ¶T
1 + r$
fT = s0 .
1 + r£

6.4 Futures Contracts

Like a forward contract, a futures contract is a binding, legal agreement to

buy (take delivery of) or sell (make delivery of) a specified quantity of a
commodity or asset, at a specified future date, at a specified price.

There are, however, some significant differences between forward and

futures contracts. First, while a forward contract is a custom agreement

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between two parties, futures contracts are standardized with regard to un-
derlying asset or commodity, quantity, delivery date, and delivery location,
and are traded on organized exchanges under strict rules enforced by the ex-
change. The exchange is a party to all the futures contracts sold and bought
at the exchange. As a matter of law, a futures contract is a contract between
an investor and the exchange. The exchange maintains a neutral financial
position in the market by transacting purchases and sales of futures con-
tracts simultaneously. In particular, the exchange sells a futures contract to
an investor only if there is another investor who is willing to buy a futures
contract from the exchange for the same quantity, delivery date, and price.
The investors, however, are mutually anonymous and assume no contrac-
tual obligations with each another. The contractual obligations are entirely
between the investor and the exchange.

Second, the default risk of futures contracts is much lower than that of
forward contracts. With a forward contract there is always some risk that,
when the delivery date arrives, either the seller will be unable to deliver the
commodity or the buyer will be unable to pay for it. With a futures contract,
however, the exchange, as the intermediary, guarantees the performance of
buyers and sellers of futures contracts through the use of performance bonds
called margin accounts. Whenever a trader buys or sells a futures contract,
he is required to deposit a determined amount of cash in a margin account
held by his broker. The size of the margin account is typically 5-15% of
contract value, approximately equal to the maximum probable daily loss
on a contract. A trader’s margin account is subsequently adjusted daily
according to the profit or loss on the futures position on that day. This
practice is known as marking-to-market. If the mark to market results in a
balance that is less than the margin requirement established by the exchange,
then the trader is issued a margin call, requiring the trader to deposit more
cash in his margin account to bring it back up to the required level. If a
trader fails to comply with a margin call, the broker is required to close the
trader’s position, thereby limiting the possibility of a loss.

When discussing futures contracts, several technical terms must be clearly

understood. The spot price refers to the price of the commodity or asset for
immediate delivery on a given date. The futures price is the price of the
commodity or asset for delivery at a future date, called the delivery date.

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At any time, futures contracts for commodities and assets are available for
multiple delivery dates. Thus, while there is only one spot price at any given
time, there are generally more than one futures price corresponding to the
delivery dates of the various futures contracts traded on the exchange. An
investor can take one of two positions in a futures contract. An investor who
takes a long position agrees to buy the commodity or asset at the delivery
date at the stated futures price. An investor who takes a short position agrees
to sell the commodity or asset at the delivery date at the stated futures price.

Users of forward and futures contracts include hedgers and speculators.

A hedger buys or sells in the futures market to secure the future price of a
commodity they must buy or sell at a later date in the cash market. This
helps them protect against price risk. Speculators, on the other hand, do not
aim to own the commodity in question. Rather, they buy and sell futures
contracts seeking to profit by anticipating increases or decreases in the price
of the underlying asset. Speculators serve an important function in futures
markets because they provide liquidity to the market.

In practice, most futures contracts (over 99%) are settled, not by making
or accepting delivery, but rather by taking an opposite position in the market.
Thus, a farmer that sells a futures contract, obligating him to deliver a
certain amount of grain at a location on a specified delivery date, will instead
subsequently buy a futures contract for the same amount and delivery date,
creating a net position in which the farmer needs neither make nor accept
delivery of the commodity at the location and on the date specified in the
futures contract. The farmer will sell his grain on the spot market. However,
as the following example illustrates, the net result of the cash sale and the
futures position guarantees the farmer’s income.

Example 6.1 One June 1, a farmer takes short position in the futures mar-
ket, selling 10,000 bushels of November 1 wheat at the then futures price of
$2 per bushel. On the same date, a baker takes a long position in the futures
market, buying 10,000 bushels of November 1 wheat at $2.00 per bushel. On
November 1, the farmer and the baker liquidate their futures market position
and, respectively, buy and sell wheat on the spot market. The net cash flows
to the farmer and baker on November 1 are illustrated in the following tables.

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 Farmer Wheat Price on November 1
$1.50 $2.00 $2.50
Wheat Sales $15,000 $20,000 $25,000
Futures Payoff $5,000 $0 -$5,000
Net Cash Flow $20,000 $20,000 $20,000

Baker Wheat Price on November 1

$1.50 $2.00 $2.50
Wheat Purchases -$15,000 -$20,000 -$25,000
Futures Payoff -$5,000 $0 $5,000
Net Cash Flow -$20,000 -$20,000 -$20,000

A futures contract is highly standardized. As an example, consider the

specification of a Chicago Board of Trade Corn Futures Contract:

• Contract Size. 5,000 bushels

• Deliverable Grades. No. 2 Yellow at par, No. 1 yellow at 6 cents per

bushel over contract price and No. 3 yellow at 6 cents per bushel under
contract price.

• Price Quote. Cents per bushel in increments of 1/4 cent/bu ($12.50/con-

tract).

• Contract Months. Sep, Nov, Jan, Mar, May, Jul, Aug

• Last Trading Day. The business day prior to the 15th calendar day of
the contract month.

• Last Delivery Day. Second business day following the last trading day
of the delivery month.

• Trading Hours. Open Auction: 9:30 a.m. - 1:15 p.m. Central Time,
Mon-Fri. Electronic: 6:31 p.m. - 6:00 a.m. and 9:30 a.m. - 1:15 p.m.
Central Time, Sun.-Fri. Trading in expiring contracts closes at noon
on the last trading day.

• Ticker Symbols. Open Auction: S. Electronic: ZS.

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 • Daily Price Limit. 50 cents/bu ($2,500/contract) above or below the
previous day’s settlement price. No limit in the spot month (limits are
lifted beginning on First Position Day).

• Margin Information. See CBOT website.

6.5 Option Contracts

An option is a contract that gives the owner the right, but not the obligation,
to buy or sell a specified asset at a specified price, on or by a specified date.
A put option confers to the owner the right to sell the asset. A call option
confers to the owner the right to buy the asset. Put and call options are
traded for many assets, including corporate stocks, major currencies, and
major stock indices. The majority of options traded on exchanges, however,
are options on futures contracts traded on the exchanges.

An option involves two parties. The owner or purchaser of a put (call)

option obtains the right to sell (buy) an asset at a specified price by paying
a premium to the writer or seller of the option, who assumes the collateral
obligation to buy (sell) the asset, should the owner of the option choose to
exercise it. The owner is said to take a long position in the option; the writer
is said to take a short position in the option.

When discussing option contracts, several other technical terms must be

clearly understood. The strike price or exercise price is the price at which
the commodity or asset may be bought or sold by the owner of the option
under the terms of the option contract. The expiration date, exercise date,
or maturity refer to the date at which the option expires or, equivalently, the
last date on which the owner may exercise his option. An American option
may be exercised at any time up to expiration date. A European option on
the other hand, may be exercised only on the expiration date. An option
is said to be in the money if its immediate exercise would produce positive
cash flow. Thus, a put option is in the money if the strike price exceeds the
spot price of the underlying asset and a call option is in the money if the
spot price of the underlying asset exceeds the strike price. An option that is
not in the money is said to be out of the money.

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 As seen in Figure 18, the payoff from a put option at the expiration date is
a function of the strike price K and the spot price sT of the underlying asset
on the delivery date. From this diagram we conclude that if a put option is
held until expiration (which must be so for a European option, but not an
American option) then the option will be exercised if, and only if, sT < K,
in which case the owner of the option will realize a net payoff K − sT > 0
and the writer of the option will realize a net payoff sT − K < 0.

Payoff Payoff

0 0
K ST K ST

Short Long

Figure 18: Payoff From Put Option

As seen in Figure 19, the payoff from a call option at the expiration date is
a function of the strike price K and the spot price sT of the underlying asset
on the delivery date. From this diagram we conclude that if a call option is
held until expiration (which must be so for a European option, but not an
American option) then the option will be exercised if, and only if, sT > K,
in which case the owner of the option will realize a net payoff sT − K > 0
and the writer of the option will realize a net payoff K − sT < 0.

In interpreting the payoff diagrams for put and call options, one must
keep in mind that options are bought and sold at a premium. Although
the cash flow at expiration for an owner of an option is nonnegative, the
owner paid a premium to acquire the option initially. Similarly, although the
cash flow at expiration for the writer of an option is nonpositive, the writer
received a premium to write the option initially. Thus, the net cash flow

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 Payoff Payoff

0 0
K ST K ST

Short Long

Figure 19: Payoff From Call Option

from an option over time can be either positive or negative for the owner or
writer alike.

The premiums P and C, respectively, on European put and call options

with common strike price K and expiration date T years must satisfy a a
so-called put-call parity relation in order to avoid arbitrage. To derive this
relation, assume that the underlying asset currently trades at a spot price
s0 and the annual yield on a risk-free bond maturing in T years is r. Let
δ = (1 + r)−1 denote the annual discount factor for bonds.

Consider now the following four transactions: 1) buy the underlying asset
at the spot price s0 with the intent to sell it at time T ; 2) sell a risk-free bond
with face value K; 3) buy a put option with strike price K and expiration
date T , paying the put premium P ; and 4) write a call option with strike
price K and expiration date T , receiving the call premium C. The cash flow
from these transactions at time T will depend on the spot price sT of the
underlying asset at time T :

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 Cash Flows
Transaction t=0 t = T, sT < K t = T, sT > K
Buy Asset −s0 sT sT
Sell Bond δT K −K −K
Buy Put −P K − sT 0
Write Call C 0 K − sT
Net −s0 + δ T K − P + C 0 0

These transaction, as a whole, create a portfolio that provides a sure

payoff of zero at time T . In order to avoid arbitrage, the net cash flow from
these transactions at time 0 must be zero, implying

s0 + P = (1 + r)−T K + C.

6.6 Models of Asset Prices

The market premium for an option or other derivative can be derived only if
assumptions are made regarding how the price of the underlying asset behaves
over time. The simplest, and the most common, assumption made regard-
ing the behavior of an asset price is that it is a continuous-time stochastic
processes that exhibits simple geometric Brownian motion. In particular, it
is assumed that the rates of return on the asset over infinitesimally small in-
crements of time ∆t are independently normally distributed with mean µ∆t
and variance σ 2 ∆t. That is,

St+∆t − St
∼ N (µ∆t, σ 2 ∆t)
St

where St is the price of the asset at time t. In discussing asset price processes,
we adopt the convention of measuring time in years and refer to µ as the drift
of the asset price process and to σ as the volatility of the asset price process.

133
 Using a theorem from Stochastic Calculus6 , it can be shown that assuming
that the asset price follows simple geometric Brownian motion is equivalent
to assuming that, over infinitesimally small increments of time ∆t, changes in
the log of the asset price are independently normally distributed with mean
(µ − 0.5σ 2 )∆t and variance σ 2 ∆t. That is,

log St+∆t − log St ∼ N ((µ − 0.5σ 2 )∆t, σ 2 ∆t).

Another particularly simple model for the behavior of asset prices is that,
over infinitesimally small increments of time ∆t, the price either goes up by
a factor u with probability p or goes down by a factor of 1/u with probability
1 − p, where u > 1. That is


 St u
 with probability p
St+∆t =


St /u with probability 1 − p

or, equivalently, that


 log St + log u
 with probability p
log St+∆t =


log St − log u with probability 1 − p.

This model is known as the binomial model of asset prices, since the distri-
bution of the log of the asset price St at a date t, conditional on the price of
the asset S0 at time 0, is simply a sum of simple Bernoulli trials, and thus
possesses a binomial distribution.

A remarkable fact is that the simple geometric Brownian motion model

and the binomial model are equivalent in that they imply the same asset price
6
The theorem is known as Ito’s Lemma, a discussion of which is beyond the scope of
these lecture notes.

134
dynamics as ∆t approaches 0, provided that the parameters of the binomial
model are chosen to be

√
u = eσ ∆t

and

eµ∆t − 1/u
p=
u − 1/u

This is a very convenient fact, since in deriving theoretical results or devising

numerical techniques for the pricing of options or other derivatives, one is
free to choose whichever of the two representations of asset price dynamics
is most convenient.

Both the simple geometric Brownian motion model and the Binomial
model imply that the conditional distribution of the asset price St at time t,
given the asset price S0 at time 0, is lognormal. In particular, the distribution
of St /S0 is lognormal with parameters (µ − 0.5σ 2 )t and σ 2 t; this is the same
as saying that the conditional distribution of log St − log S0 is normal with
mean (µ − 0.5σ 2 )t and variance σ 2 t. Using standard results from probability
theory, it follows that

E(St /S0 ) = eµt

2
V (St /S0 ) = e2µt (eσ t − 1)

Numerically simulating the path of an asset price that follows geometric

Brownian motion with drift µ and volatility σ over an interval of time [0, T ] is
straightforward. First, one divides the time interval into into n subintervals
of equal length ∆t = T /n. Next, one generate a sequence zi of n indepen-
dent standard normal variates using a numerical random number generator
(included in Matlab and most other numerical programs). Given the price of

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the asset S0 at time 0, a representative sequence of asset prices Si at times
t = i∆t, for i = 1, 2, 3, . . . , n, can then be generated recursively as follows:

√
log Si = log Si−1 + (µ − 0.5σ 2 )∆t + zi σ ∆t

Three simulated paths for an asset price with µ = 0.1, σ = 0.1, T = 1, and
S0 = 1 are illustrated in Figure 20. In each case, n = 10, 000.
1.3

1.25

1.2

1.15
Asset Price

1.1

1.05

0.95

0.9
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Time in Years

Figure 20: Simulated Geometric Brownian Motion

In order to replicate the behavior of the price of a given asset, the drift µ
and volatility σ must be specified. This is typically done by estimating these
parameters from historical return data for the asset. Suppose you have n + 1
observations, s0 , s1 , s2 , . . . , sn , on a stock price taken at equal intervals of time
∆t = T /n over a period of T years. If ui = log(si /si−1 ) for i = 1, 2, 3, . . . , n,
then an unbiased estimate of the volatility of the stock price is provided by

v
u Pn
u (ui − ū)2
σ̂ = t i=1
(n − 1)∆t

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where ū is the mean of the ui . An estimate of the drift term µ is provided
by

µ ¶
1 sn
µ̂ = log .
T s0

Estimates of the drift term, however, as we shall see, are not needed for the
valuation of derivatives.

6.7 Risk Neutral Valuation

The principle of risk neutral valuation, introduced in Chapter 4, maintains

that, in a complete, arbitrage-free market, the price of a security at any point
in time equals the expected future payoff of the security, computed using the
risk-neutral probabilities, discounted at the risk-free rate. This result will
provide us with the key to valuing options and other derivatives.

Consider a risky asset whose price follows simple geometric Brownian

motion with drift µ and volatility σ. Using the binomial representation of
the asset price process, if the price the risky asset at time t is St then its
price in time t + ∆t will either equal St u with probability p or St /u with
probability 1 − p, where

√
u = eσ ∆t

and

eµ∆t − 1/u
p=
u − 1/u

The possible movements in the asset price between time t and time t + ∆t
are illustrated in Figure 21.

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 · Su
t

S
t ·

1−p

· St/u

t t+∆ t

Figure 21: Binomial Model of Asset Price

Suppose now that there exists a risk-free asset with continuously com-
pounded rate of return r, so that a dollar invested in the asset at time t will
produce a payoff of er∆t at time t + ∆t. Then the risk-free asset and the risky
asset form a complete market with respect to the two possible payoffs of the
risky asset at time t + ∆t.7 In particular, using the notation of Chapter 4,
the price vector at time t for the two assets is (1, St )0 and the payoff matrix
at time t + ∆t is

" #
er∆t St u
A= .
er∆t St /u

From the results presented in Chapter 4, the risk-neutral probability that

the price of the risky asset will rise in ∆t is

er∆t − 1/u
π= .
u − 1/u
7
All this is required is that ∆t < σ 2 /r2 .

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The probability that the price of the risky asset will fall is

u − er∆t
1−π = .
u − 1/u

Thus, the risk-neutral probabilities of an up or down movement in price are

identical to the probabilities of an up or down movement in the underlying
asset price, except that the drift term µ is replaced by the continuous risk-free
rate r. The importance of this result cannot be overstated: to the risk-neutral
investor, the asset follows simple geometric Brownian motion with drift r.

Consider now a derivative asset, whose value is determined by the price of

the risky asset. Since the risky asset can assume only two possible values next
period, the derivative asset also can assume only two values. Let fu denote
the value of the derivative next period if the price of the risky asset rises to
St u and let fd denote the value of the derivative next period if the price of
the risky asset falls to St /u. The, according to the principle of risk-neutral
valuation, the price of the derivative at time t is simply the expected value of
the derivative at time t + ∆t, computed using the risk-neutral probabilities,
discounted at the risk-free rate. That is, if f is the value of the derivative at
time t, then

f = e−r∆t (πfu + (1 − π)fd ) .

6.8 Black-Scholes Formula

In the preceding section we found that if an asset follows geometric Brownian

motion with drift µ and volatility σ, then the risk-neutral investor sees the
asset price as following geometric Brownian motion with drift r and volatility
σ, where r is the continuously compounded annual risk-free rate of return.
This implies that, to the risk-neutral investor, the distribution of the asset
price St at time t, given the asset price S0 at time 0, is lognormal. In
particular, the risk-neutral distribution of St /S0 is lognormal with parameters
(r − 0.5σ 2 )t and σ 2 t.

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 Consider then, a European call option that expires in T years. The
premium one must pay for this option at time t = 0 will be the expected
payoff of the option, computed using the risk-neutral distribution, discounted
to the present at the risk-free rate. In particular, the premium is

C = e−rT Ẽ0 max{St − K, 0}

where K is the strike price of the option and Ẽ0 is the expectation taken
with respect to the risk-neutral distribution conditional on the information
known at time t = 0.

Computing the expectation of the call option payoff with respect to the
risk-neutral distribution is an exercise in the Calculus, which will be omitted
here. We simply present the result:

C = SN (d1 ) − e−rT KN (d2 )

where

log(S/K) + (r + 0.5σ 2 )T
d1 = √ .
σ T

√
d2 = d1 − σ T .

Here, S is current price, K is strike price, σ is volatility, T is time to expi-

ration, r is the continuously-computed annual risk-free rate of return, and
N is cumulative distribution function for a standard normal variate. This is
the Black-Scholes formula for the premium of a call option of an European
option on a assuming that the asset pays no dividends and is costless to
store. Variants of the formula to allow for dividends and storage costs are
well-known, but will not be discussed here.

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 By a similar set of arguments, the premium for a European put option
that expires in time T and has strike price K is

P = e−rT KN (−d2 ) − SN (−d1 )

where d1 and d2 are defined as above and N is the cumulative distribution

function for a standard normal variate.

Example 6.2 A call option with an exercise price of $50 has three months
to expiration. The continuously compounded annual risk-free rate is 4%; the
stock currently trades for $45; and the volatility of the asset price is 0.4.
Then T = 0.25, K = 50, S = 45, σ = 0.4, and r = 0.04. According to the
Black-Scholes formula,

log(45/50) + (0.04 + 0.5 · 0.42 ) · 0.25

d1 = √ = −0.3768.
0.4 0.25

√
d2 = d1 − 0.4 · 0.25 = −0.5768.

and the price of the European call option is

C = 45 · N (−0.3768) − e−0.04·0.25 50 · N (−0.5768) = 1.9307.

6.9 Valuing American Options

Because American options have an early exercise feature, they cannot be

priced using the Black-Scholes formula. The price of an American option,
however, can be derived numerically using a recursive procedure in which the
time to expiration of the option is divided into many smaller subintervals.

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 We now show how this procedure would be implemented, assuming that
time to expiration is divided into four sub-intervals, keeping in mind that
for the procedure to provide accurate answers, one would have to divide
the time interval into a much larger number of subintervals. The procedure
is relatively easy to implement in Matlab, so computing the American put
option premium using many subintervals, which would be nearly impossible
by hand, is easily handled by a computer.

By way of example, let us price an American option under the following

assumptions:

Stock price S 40
Strike price K 45
Interest rate r 5%
Expiration T 0.75
Volatility σ 40%
Time periods N 3
Time interval ∆t 0.25

Under these assumptions, the binomial asset price model approximation

would be to assume that the asset price either goes up by a factor u or down
by a factor 1/u in each subperiod, where

√
Up factor u = eσ ∆t = 1.2214
r∆t −1/u
Up probability π = e u−1/u = 0.4814
−r∆t
Discount factor δ=e = 0.9876

The possible states of the asset price over time are represented graphically
in Figure 22. The asset prices are written above the nodes; the price of the
option is written below the node.

6.10 Exercises

1. Oscar stock currently trades at $92 per share. One year from now,
Oscar is expected to pay a dividend of $1.70 per share. If the annual

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 72.88

·
π
59.68 0

· 1−π
π
48.86 0 48.86

· 1−π ·
π π
40.00 3.21 40.00 0

· 1−π · 1−π
π
7.83 32.75 6.27 32.75

· 1−π ·
π
12.30 26.81 12.25

· 1−π

18.19 21.95

·
23.05

t=0 t=∆ t t=2∆ t t=3∆ t=T

Figure 22: Binomial Tree

yield on a risk-free bond maturing in one year is 7%, what is the forward
price of one share of the stock for delivery in one year? In lecture,
I covered futures-spot pricing relations only for non-dividend paying
stocks. Thus, you will have to apply your analytical skills to extend
the relationship to accommodate dividend the payment. Assume that,
under the terms of the forward contract, the stock is to be delivered
after the dividend is paid.

2. A stock currently trades at $50 per share. At the end of six months,
the stock price will be either $45 or $55. The annual yield on a risk-free
bond maturing in six months is 10%. What are the risk-neutral prob-
abilities of a price increase and price decrease? Use these probabilities
to infer the current prices of European call and put options, both with
strike price $50 and expiring in 6 months.

3. A non dividend paying stock that currently trades at $200 per share will
be worth either $200 or $230 one year from today with equal probability.

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 A European put option on one share of the stock that expires one year
from today and with a strike price of $211.50 currently sells for $4.
What is the annual yield on a risk-free bond maturing in one year?

4. The stock of Smith Ltd. currently trades for $500 per share. A Eu-
ropean call option on one share of stock that expires in one year with
exercise price $200 currently sells for $400 and a European put op-
tion on one share of that expires in one year with exercise price $200
currently sells for $84.57.

(a) Infer the current yield on a one-year zero-coupon U.S. government

bond.
(b) If the current actual yield on a one-year zero-coupon U.S. gov-
ernment bond is 9%, construct a portfolio that that whose payoff
tomorrow will be zero with certainty, but which generates a certain
profit today.

5. Using the put-call parity relationship for European stock options as a

guide, construct a replicating portfolio for a European call option on
one share of stock with strike price K and expiration one year from
today. Your replicating portfolio may include bonds, the stock, and a
put option on the stock. The yield on a one year T-bill is r.

6. Consider a non-dividend paying stock with expected annual return 15%

and annual volatility 35%. The stock currently sells for $69 per share
and the continuously compounded risk-free annual rate of return is 5%.

(a) Using the Black-Scholes formula, compute the premium on a Eu-

ropean put option with strike price 70$ that expires four months
from today.
(b) Using the Matlab function BinomialOption, compute the pre-
mium for the option in part (a).
(c) Using the Matlab function BinomialOption, compute the pre-
mium for the option in part (a), assuming that it is an American
put option that can be exercised early.

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