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# Arena Dai

Price Options

Stochastic Process

##  Investigate random value of price changes where future value is uncertain

 Any variable whose value changes over time in an uncertain way is said to follow a
stochastic process
 Can be classed as:
o Discrete – value of variable changes only at certain fixed points in time
o Continuous – value of variable can change at any time
 Alternatively, a stochastic process can be classified as discrete variable or continuous
variable
 Stock price is assumed to follow a continuous-variable and continuous-time stochastic
process
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##  Determining the changing patterns of stock prices

Stochastic Process

future

and variance =T

## Generalised Wiener Process  Mean change and variance change are

proportional to time

## Ito Process  Like the GBM except mean and variance

changes are functions of time and the
variable being modelled

##  GWP, IP & BM all fall under Markov process

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o Markov process – stock future value depends on current value only, not past
value

Process:

2. Make assumptions about future value of stock
3. Calculate the upstate and downstate
4. Then, discount payoff to present value

## Wiener process Insert formula

 E is randomly selected
 E is characterised by
 Normal distribution
 Mean = 0
 Stdev = 1
 Not practical as stock price can’t be negative
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## Generalised Wiener Insert formula

process  a is fixed at every period
 ‘Scatter’ of risk component
 Not practical as a return cannot be applied for all stocks e.g. compare
initial stock price of 1 and 100
Ito Process Insert formula
 a and b are functions of price i.e. this assumption converts constants a
& b into functions
Geometric Brownian Insert formula
Motion  Special form of Ito Process
 Describes changing price of stocks only

Markov Process

##  Future movements of a variable depend on current position

o The history does not matter
 Therefore, Expectation of past price = expectation of today’s price only
 Changes in value at different time intervals are independent
o The stocks return on day 1 is independent of the stocks return on day 2
 As the returns are independent – and thus, uncorrelated – the variances of the stock
return over a period of time are additive
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##  Cannot produce consistently superior returns based on history of stock prices

 Technical analysis does not work
 Markov Process is consistent with weak-form market efficiency
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## Generalised Wiener Process

 Wiener Process has a drift rate of 0 (a=0) and a variance rate of 1 (b=1)

## 𝑑𝑥 = 𝑎(𝑥, 𝑡)𝑑𝑡 + 𝑏(𝑥, 𝑡)𝑑𝑧

 Definitions:
o Drift rate: mean change per unit of time
o Variance rate: variance per unit of time
 GWP: drift rate and variance rate are set equal to any chosen constants
 The Wiener Process is a special form of GWP
o WP  a=0, b=1

WP GWP
∆𝑥 = 𝜀√∆𝑡 → 𝑑𝑧 𝑑𝑥 = 𝑎𝑑𝑡 + 𝑏𝑑𝑧
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 Rewatch lec

##  GWP is not appropriate due to two principal reasons

1) GWP is normally distributed therefore it can become negative
a. However, stock prices cannot be negative therefore a more
reasonable model would assume that continuously compounded
returns are normally distributed

2) If stock prices follow GWP, then the variance of the stocks prices is
constant regardless of price level
a. It is more reasonable to assume returns have a constant variance,
regardless of price level
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Ito Process

 In an Ito process:
o Drift rate and variance rates are functions of time and the underlying variable

## The Process for a Stock Price

 GWP fails to capture the aspect of stock prices i.e. the expected percentage return
required by investors from a stock price is independent of the stock’s price e.g. if
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investors require a 14% return when the stock price when it is \$10, then, ceteris
paribus, they will also require a 14% return when the stock is \$1000
o Recap: GWP  stock price has a constant expected drift rate and a constant
variance rate
 Therefore, the assumption of constant drift rate is not appropriate and needs to be
replaced by the assumption that the expected return (expected drift divided by stock
price) is constant

The Parameters

##  u is the expected annualised return earned in a short period of time

o Dependent on the risk of the return from the stock and interest rates in the
economy
o Higher interest rates = higher expected returns on any given stock
 Note that: the value of the derivative dependent on a stock is generally independent
of u
 Sigma is important in discerning the value of derivatives

Ito’s Lemma

 Price of a stock option is a function of the underlying stocks price and time
 The price of any derivative is a function of the stochastic variables underlying the
derivative and time
 Suppose variable x follows Ito’s process

## 𝑑𝑥 = 𝑎(𝑥, 𝑡)𝑑𝑡 + 𝑏(𝑥, 𝑡)𝑑𝑧

 Where,
o dz is a Wiener Process
o a & b are function of x & t
 Variable x has a drift rate of a and a variance rate of b2
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##  Illustrates Ito’s lemma

 Refer to Page 292
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## The Lognormal Property

 Use Ito’s lemma to derive the process followed by ln(S) when S follows the process
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Summary

##  Markov process: PV of variable is relevant for predicting the future

o History is irrelevant
 Wiener process dz
o Describes normally distributed variable
o Drift rate = 0
o Variance rate = 1
o Thus, if variable value is x0 at time 0, then at time T, it will have:
 Mean x0
 Stdev √T
 Generalised Wiener Process
o Evolution of normally distributed variable with a drift rate of a per unit time
and a variance rate of b2 per unit time where:
 a and b are constants
o Thus, if variable value is x0 at time 0, then at time T, it will have:
 Mean x0 + aT
 Stdev b√T
 Ito process
o Drift and variance rate of x can be a function of both x itself and time
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## o Change in x in a very short period of time is normally distributed but change

over longer periods of time is likely to be non-normal
 It’s Lemma
o Calculates the stochastic process followed by a function of a variable from the
stochastic process followed by the variable itself
 Pricing of derivatives
o Key point: Wiener process (dz) underlying the stochastic process for the
variable is the same underlying the stochastic process for the function
underlying the variable
 Both are subject to the same underlying source of uncertainty
 The stochastic process assumed for a stock price is Geometric Browning motion
(GBM)
o Returns to the holder of the stock in a small period of time is normally
distributed
o And, returns in two non-overlapping periods are independent
 The value of a stock price at a future time has a lognormal distribution
 The B-S model is based on the GBM assumption

Process Equation
Wiener Process ∆𝑥 = 𝜀√∆𝑡
Generalised Wiener 𝑑𝑥 = 𝑎𝑑𝑡 + 𝑏𝑑𝑧
Process  Where a & b are constants

∆𝑥 = 𝑎∆𝑡 + 𝑏𝜀√∆𝑇

## Ito’s process 𝑑𝑥 = 𝑎(𝑥, 𝑡)𝑑𝑡 = +𝑏(𝑥, 𝑡)𝑑𝑧

∆𝑥 = 𝑎(𝑥, 𝑡)∆𝑡 + 𝑏(𝑥, 𝑡)𝜀√∆𝑡

##  Where a & b are constants of price

Geometric Brownian 𝑑𝑆 = 𝜇𝑆 𝑑𝑡 + 𝜎𝑆 𝑑𝑧
Motion: a special
∆𝑆 = 𝜇𝑆∆𝑡 + 𝜎𝑆𝜀√∆𝑡
form of Ito process
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Ito’s lemma

How do we select 𝜀?

 Randomly selected
 Normally distributed
 Mean = 0

GWP Limitations

 Returns are reflected differently depending on stock price e.g. \$3 return on a stock
price of \$3 and \$300  reflected as 100% and 1% return
 Ito’s process accounts for this limitation

MODEL
CONCEPTS

##  Merton’s approach to deriving B-M model

 How volatility can be estimated from
o Historical data
o Or, from option prices
 B-M model extending to European Calls and Puts
 Pricing American call options on dividend paying-stocks using B-M model

## LOGNORMAL PROPERTY OF STOCK PRICES

 Stock price behaviour used by the B-M model assumes that percentage changes in
stock price within a short time period are normally distributed.
 Define:
o u = expected return on stock per year
o o = volatility of stock price per year
 Approach Example 14.1 on Page 300
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 Variables with lognormal distribution can take any value between 0 and ∞
o Unlike normal distribution, lognormal is skewed so that mean, median and
mode take on different values
 Insert lognormal graph
 Approach Example 14.2

##  Lognormal property of stock prices provides information on the probability

distribution of the continuously compounded rate of return earned on a stock
between time 0 and T
 Refer to example 14.3 to define continuously compounded rate of return

##  Expected return, u, required by invested from a stock depends on:

o Stocks riskiness
o Interest rates in the economy
 the value of the stock when expressed as a value of the underlying stock does not
depend on u
 Approach equations

VOLATILITY

##  Measure of uncertainty on the returns by the stock

 Stock volatility typically ranges between 15% and 60%

## CONCEPT UNDERLYING THE B-M DIFFERENTIAL EQUATION

 The differential equation must be satisfied by the price of any derivative dependent
on a non-dividend paying stock
 Arguments applied to B-M differential equation:
o Assume no arbitrage to value binomial stock price movements thereby setting
up a riskless portfolio consisting of a position in the derivative and a position in
the stock
o Given no arbitrage, return from portfolio must be the risk-free interest rate, r
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PRICING DERIVATIVES

##  The price of a derivative is a function of:

o The price of the underlying process
 Which follows a stochastic process
o Time
 Ito Lemma is used to characterise the behaviour of a function of a stochastic variable
o The derivatives process is described as using the process followed by the
underlying stock

PARAMETERS

µ Stdev
 The expected continuously  Stock price volatility
compounded return earned by the  Interpreted as the stdev change in
stock per year stock price in one year
 Value of derivative dependant on a
stock is usually independent of
return

## B-S-M DIFFERENTIAL EQUATION

ASSUMPTIONS:
 Stock price follows GBM (ds = uSdt + stdev.dz)
 Short-selling of securities is permitted
 There are no transaction costs or taxes
 Securities are perfectly divisible
 There are no dividends during the life of an option
 There are no arbitrage opportunities
 The risk-free rate of interest is constant and the same for all maturities
o r is not stochastic and remains constant

##  Assumes that stock price follows GBM

o However, GBM does not capture jumps in stochastic process
 E.g. dramatic share price movements due to market news
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##  Assumes r is constant – it is stochastic

 Assumes stdev is constant – it is stochastic
 Overall, there is a pricing bias

##  An American call on a non-dividend paying stock should never be exercised early

 An American call on a dividend-paying stock should be exercised immediately prior to
an ex-dividend date
o i.e. before the price drops due to the dividend payment
 Consider exercising before the final dividend:
o If call is exercised before dividend payment
 Holder receives intrinsic value = S(tn) – k
o If call is not exercised, the stock price will drop to S(tn) – Dn
 NB: call price is bounded above: C(tn+) ≥ S(tn) – Dn – ke-r(T-tn)
o Where RHS is min. value of option when holding a call
 If S(tn) – k ≤ S(tn) – Dn – ke-r(T-tn) then the intrinsic value is LESS than the call price
o DO NOT EXERCISE the call and continue to hold it
 It may be optimal to exercise immediately prior to an ex-dividend date if:

## 𝐷𝑖 > 𝑋(1 − ⅇ −𝑟(𝑡𝑖−1 −𝑡𝑖 ) )

 Where,
 Di is dividend
 ti is the time right before the stock going ex-dividend

## PRICING FOR AMERICAN CALL OPTIONS

 For an American call option on a non-dividend paying stock, the value is the same as
the value of the corresponding Euro call option
 For an American call option on a dividend-paying stock, B-S suggests an
approximation procedure
o Calculate the prices of Euro call options that mature at times T and Tn (time
you may consider exercising the option prior to maturity)
o Then, approximate the American price as the greater of the two
 Alternatively, the Binomial Model can be utilised

INDEX OPTIONS

##  Popular underlying indices in the U.S. are:

o S&P100 Index (OEX and XEO)
o S&P 500 Index (SPX)
o Dow Jones Index times 0.01 (DJX)
o NASDAQ 100 Index (NDX)
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 U.S. exchange-traded contracts are on 100 times index & settled in cash
 OEX is American
 The others are European
 In Australia, the S&P/ASX 200 index options gave a multiplier of 10

PORTFOLIO INSURANCE

##  Portfolio insurance keeps upside open but limits downside risk

o On the other hand, hedging limits potential future gains and losses
 Portfolio insurance ensures that portfolio value does not fall below a certain level
 This is implemented by buying put options directly or using a dynamic replication
strategy with index futures
o i.e. as the market falls, we sell more index futures to account for the changing
delta of the put
 Why did this technique contribute towards the 1987 stock market crash?

PROCEDURE
1. How many Put options do we buy?
2. At what Strike price?
3. Verify decision

SUMMARY

##  The B-S differential equation is derived from creating a risk-free portfolio

 The price of any derivative on a non-dividend paying stock must satisfy the differential
equation
 Euro options can be valued as if investors were risk neutral as risk premium is not part
of the equation
 To value dividend-paying Euro options, adjust the PV of asset
 To value American options, use Black’s approximation or binomial trees
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## CHAPTER 16: OPTIONS ON STOCK INDICES

AND CURRENCIES
PORTFOLIO INSURANCE

##  Index options are settled in cash

 Portfolio managers use index options to reduce downside risk
 Cost of hedging increases as beta of a portfolio increases
o Because more put options are required and have a higher strike price

CURRENCY OPTIONS

##  Currency options trade on the NASDAQ OMX

 Also, actively traded in OTC market
o Large trades are possible in this market, as well as, tailored strike prices,
expiration date and other features
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 Alternatively, there are liquid futures options markets for e.g. major currencies vs. the
US dollar
 Currency options are utilised by corporations to buy insurance when they have FX
exposure
o It is an alternative to forward contracts

Put Call

##  A company due to receive sterling  A company due to pay sterling can

can hedge risk by buying put hedge by buying call options that
options on sterling that mature at mature at that time
that time
 Strategy ensures that cost of
 Hedge strategy guarantees that sterling will not be greater than a
exchange rate applied to sterling certain amount whilst allowing the
will not be less than the strike company to benefit from
price favourable price movements

##  Also, this allows companies to

benefit from favourable exchange-
rate movements

Notes
 Forward contracts lock in the exchange rate for a future transaction whereas
option provides insurance
 Options require a premium to be paid up front whereas forward contracts cost
nothing to enter into

## FORWARDS/FUTURES VS. OPTIONS

Forward/Futures Options
Say, we sell FOREX futures/forwards: Say, we buy options on FOREX:

##  Cheap  Expensive to buy options

 Reduce downside risk  Reduce downside risks
 Eliminates upside potential  Keeps upside open
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RANGE FORWARDS

##  Variation on a standard forward contract for hedging foreign exchange risk

 It is the simultaneous buying and selling of options
o Buy OTM calls and sell OTM puts
 Buy/sell strategy may offset cost of options
 Range forwards ensure that the exchange rate paid/received will lie within a
certain range
 Range forwards:
o Reduce major risk
o Still exposed to little upside and downside risk
 The contract is set up so that put price = call price
o No costs when setting up a range forward contract

## Short range-forward contract Long range-forward contract

 If company knew it would  If company knew it was due to
receive Euro Pounds pay Euro Pounds
 Buy Euro put option with strike  Sell Euro put option with strike
price K1 price K1
 Sell Euro Call Option with strike  Buy Euro Call Option with strike
price K2 price K2
 Where K1 < forward exchange  Where K1 < forward exchange
rate < K2 rate < K2

##  If exchange rate as T is less than  If exchange rate as T is less than

K1, the put option will be K1, the put option will be
exercised and company can sell exercised against the company
at the exchange rate of K1 who will buy Euro at the
 If exchange rate is more than K2, exchange rate of K1
the call option is exercised  If exchange rate is more than K2,
against the company the call option is exercised and
 If exchange rate lies between K1 the company can buy Euros at K2
and K2, neither option is  If exchange rate lies between K1
exercised and the company uses and K2, neither option is
the current exchange rate at T exercised and the company uses
the current exchange rate at T
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 As strike prices of call and put in a range forward move closer, the range forward
contract becomes a regular forward
 Short range forward contract  short forward contract
 Long range forward contract  long forward contract

##  Dividends cause stock price to reduce by the amount of dividend payment

 Payment of dividend yield, q, causes growth in stock price to be less by q
 Stock price grows from So today to ST at time T
 There is the same probability distribution for the stock price at Time T in each of the
following cases:
1. The stock price starts at So and provides dividend yield at a rate of q
2. The stock price starts at Soe-qt and pays no dividends
 When valuing Euro options lasting for time T on a stock paying a known dividend yield
at a rate of q, we reduce the current stock price from So to Soe-qt and value the option
as though the stock pays no dividends

If the amount and timing of the dividends during the life of a Euro option is known, the B-S
can be used to value the option given that stock price is reduced by the PV of all dividends
during the life of an option

## PLEASE REFER TO SHEET FOR THE BELOW FORMULAS:

 Put-Call Parity
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 Pricing Formulas
 Differential Equation and Risk-Neutral Evaluation (refer to textbook)
 Valuation of European Stock Index Options
 Forward Prices
 Implied dividend yields
 Valuation of Euro Currency Options
 Forward Exchange Rates
 American Options

## IMPLIED FORWARD PRICES

 Euro calls and puts with the same strike price and time to maturity:

F0 = K + (c-p)ert

1 𝑐−𝑝+𝑘ⅇ −𝑟𝑇
q = − 𝑇 𝑙𝑛 𝑆0

 The above formula allows term structures of forward prices and dividend yields to be
estimated
 OTC Euro options are valued using forward prices (Estimates of q are not required)
 American options require the dividend yield term structure

AMERICAN OPTIONS

 It may be optimal to exercise American currency and index options prior to maturity
 American currency/index options are worth more than their Euro counterparts
 More likely to be exercised before maturity:
o Call options on high-interest currencies
 High-interest currency expected to depreciate
o Put options on low-interest currencies
 Low-interest currency expected to appreciate
o Call options with high-dividend yields
o Put options with low-dividend yields

SUMMARY

##  Index options traded on exchange are settled in cash

 Exercising an index option  receive/pay 100 times the amount by which index
exceeds strike price
 Index options are used for portfolio insurance:
o If portfolio value mirrors the index – buy one put option contract for each
100S0 dollars in the portfolio
 S0 is value of the index
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o If portfolio value does not mirror the index, B put option contracts should be
purchased for every 100So dollars in the portfolio
o Strike price of put options purchased should reflect level of insurance required
 Currency options are mostly traded on OTC markets
 They can be used to:
o Hedge foreign exchange exposure
 Receive sterling at T  buying put options maturing at T
 Paying sterling at T  buying call options maturing at T
o Create a range forward contract
 Zero-cost contract to provide downside protection whilst giving up
some upside
 The B-S can value:
o Euro options on a non-dividend paying stock
o Euro options on a stock paring a known dividend yield
o Euro options on stock indices and currencies
 Why?
o Stock index is comparable to a stock paying dividend yield
 Dividend yield is the dividend yield on the stocks that make up the
index
o Foreign currency is comparable to a stock paying dividend yield
 Foreign risk-free rate is like that of the dividend yield
 Binomial trees can be used to value American options on stick indices and currencies

INTRODUCTION

##  Spot options: when exercised, sale/purchase takes place immediately

 Futures options: exercise of option gives holder a position in a futures contract

FUTURES OPTION

 The right, but not the obligation, to enter into a futures contract at a certain futures
price at a certain date
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 Call Futures Option: right to enter into a long futures contract at a certain price and
vice versa for Put Futures
 Futures Options are generally American and expires on or a few days before the
earliest delivery date of the underlying futures contract
 They are referred to by the maturity month of the underlying futures
o There can be more option chains than Futures per year
 When a futures position is closed out immediately:
o Call payoff: max (FT – K; 0)
o Put payoff: max (K-FT; 0)
 What happens when you exercise Futures option?
o Note that the difference between last and next settlement will be applied to
the delivered Futures contract

## Call Futures Option Put Futures Option

 Holder acquires a long position in  Holder acquire short position in the
the underlying futures contract underlying futures contract
 And, a cash amount = to most recent  Cash amount = strike price LESS
settlement futures price LESS strike most recent settlement futures price
price

##  Futures contracts are:

o More liquid than the underlying asset
o Futures price is immediately known from trading on the futures exchange
o Exercising does not lead to delivery of the asset but rather, underlying futures
contract is closed out prior to delivery and therefore eventually settled in cash
 Appealing to investors
o Futures and futures options are traded in the same exchange
 Facilitates hedging, arbitrage and speculation
 More efficient market
o Future options incur lower transactions costs than spot options
 As we are trading on one exchange therefore do not have to pay

## EUROPEAN SPOT AND FUTURES OPTION

 Payoff from Euro Call with same strike price on the futures price of the asset is:

Max (FT – K; 0)
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## o Where FT is the futures price at the options maturity

 If future contract matures at the same time as the option, then FT = ST and the two
options are equivalent
 Likewise, Euro put futures option are worth the same as its spot put option when the
futures contract matures at the same time as the option
 In a nutshell: Euro Futures options and Spot options are equal when the futures
contract matures at the same time as the option
 It is common to regard Euro Spot options as Euro Future options when they are
valued in the OTC markets

## VALUATION OF FUTURES OPTIONS USING BINOMIAL TREES

 Difference between futures options and stock options is that there are no up-front
costs when a futures contract is entered into
 In a risk-neutral world, the asset price grows at r-q rather than at r when there is a
dividend yield at a rate q
 Using binomial trees
o Create a risk-free portfolio
 Short 1 option
 Long delta futures contracts
o Calculate delta and input into the risk-free equation to discern risk-free payoff
o Discount back to PV

## BLACKS MODEL TO VALUE FUTURE OPTIONS

 Blacks model is used to value Euro options on the spot price of an asset in the OTC
market
o This avoids the needs to estimate income on the asset
 Assumption that futures price follows lognormal process
 Volatility of futures price is same as the volatility of the underlying asset
 Euro futures options and Euro spot options are equal when the option contract
matures at the same time as the futures contract

## AMERICAN FUTURES OPTIONS VS. AMERICAN SPOT OPTIONS

 An American futures call option must be worth more than the corresponding
American spot call option
o American futures option can be exercised earlier  greater profit to the
holder
 American put futures option must be worth less than corresponding American spot
put option
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 If there is an inverted market where futures prices are consistently lower than spot
prices then the reverse is true i.e.
o American Call futures options are worth less than corresponding American
spot call option
o American Put futures options are worth more than their corresponding
American spot put option
 These differences still hold even when the American futures options and American
spot options expire at the same time
 The later the futures contract expires (compared to the options contract), the greater
the differences will be

##  Futures contract require no initial investment

 Its expected return should be zero in a risk-neutral world
 Therefore, the expected growth rate of the futures price is zero
 The futures price can be regarded like a stock paying a dividend yield of r
 Set q=r ensures that the expected growth of F in a risk-neutral world is zero

##  A futures contract on the option payoff

 Some exchanges trade these in preference to regular futures options

SUMMARY

##  Futures options require delivery of the underlying futures contract on exercise

Call Put
 Holder acquires a long futures  Holder acquires a short futures
position position
 Cash amount = excess of futures  Cash amount = excess of strike
price over the strike price price over futures price

 If the expiration dates for option and futures contracts are the same, a Euro futures
option is equal to its corresponding Euro spot option
 However, this is not true for American options
 If the futures market is normal:
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o An American call futures is worth more than its corresponding American spot
call option
o An American put futures is worth less than its corresponding American spot
put option
 If the market is inverted, the reverse is true

Lecture 12

Binomial Trees

##  B-T approximates movements in the price of a stock or other asset

 At each time interval, stock price is assumed to move by a proportional amount of u
and d
 Parameters p u and d are chosen to give correct values for stock price change mean
and variance in a risk-neutral world

Backwards Induction

##  Calculate values of option at the final nodes

 Work back through the tree using risk-neutral valuation to calculate value of option at
each node ensuring to test for early exercise

## Options on Indices, currencies and futures contracts

Option
Stock Indices q equals the dividend yield on the index
Foreign Currency (FOREX) q equals the foreign risk-free rate
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## Binomial Tree for Stock paying Known Dividends

 Construct a tree for the stock price less the PV(dividends) and adjusted volatility
 Create a new tree by adding PV (remaining dividends at) at each node
 This ensures that the tree combines and makes assumptions similar to when B-S
model is used for Euro options
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## Time Dependent Parameters in a binomial tree

 Making r or q as a function of time does not affect the geometry if the tree
o The probabilities the tree become functions of time
 We can make sigma a function of time by making the lengths of the time steps
inversely proportional to the variance rate
 Binomial Tree assumption is that r, q and sigma, are not stochastic  however they
are stochastic variables in reality
o Also known as time variance
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Introduction

##  There are three numerical processes to increase accuracy of pricing options:

1) Trees
a. Binomial
b. Trinomial
2) Monte Carlo Simulation (not examinable)
3) Finite differences (not examinable)

Binomial Trees

##  Can be used to value either Euro or American options

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 B-S model only provided analytic valuations for Euro options – Not American options
 Used to approximate movements in the price of a stock or other asset
o Solve factors of upstate and downstate
o Find probability of up and down
 Binomial tree valuation
o Divide life of option into many small time intervals of length delta t
o Assumption that at each time interval, the price of the underlying asset moves
from initial value of S to either Su or Sd

Parameters p, u and d

 P, u and d are chosen so that the tree gives correct values for the mean and variance
of stock price changes during time interval delta t in a risk-neutral world

Risk-Neutral Valuation

 Risk-Neutral Valuation states that an option (or other derivative) can be valued on the
assumption that the world is risk neutrala9
o NOTE: The probability of payments is risk-neutral BUT investors are still risk-
averse
 Therefore, for valuation purposes; we use the following procedure underlying
binomial trees:
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o Assume expected return from all traded assets is the risk-free interest rate
o Value payoffs from the derivative by calculating their expected values and
discounting at the risk-free rate

Determination of p, u and d

 As we are working in a risk-neutral world, the expected return from the asset is the
risk-free interest rate, r
 Expected return in form of capital gains is r-q

## Parameters of assert paying dividend yield of q

 When delta t is small; Cox, Ross and Rubinstein proposed a solution to these
equations:
 Note:

## o Delta t is the time between each state of the tree

o The value of a differs depending on the options underlying the option
 When futures underlie an option, a = 1
 Given the assumption that the growth rate of futures should be
0. Therefore, r – q = 0 and a = 1
 Forex options: r(d) – r(f)
 Which is domestic?
o Consider: how many domestic currencies exchange for
one unit of foreign currency i.e. foreign currency
appears as 1 unit

## Working backward through the tree

 The tree shows future possible price of underlying assets but what about payoff
values of the options?
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 Options are evaluated by starting at the end of the tree and working backward
 At the final node, the option value is

 Using risk-neutral valuation to calculate the value of the option at each node, we
work back through the tree and test for early exercise when appropriate

With Early
Exercise

Without Early
Exercise

Using the Binomial Tree for Options on Indices, Currencies, and Futures Contracts

##  As with the B-S Model, for options on:

o Stock indices – q = dividend yield on the index
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## o FOREX – q = foreign risk-free rate

o Futures – q = r

## Binomial Model for a Dividend-Paying Stock

Procedure

1) Construct a tree for the stock price less the PV(dividends) with adjusted volatility σ*

## 2) Create a new tree by adding the PV(dividends) at each node

3) This ensures that the tree recombines and makes assumptions to those when the B-S
model is used for Euro Options

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##  Improves the accuracy of the pricing of an American Option

 It uses the same tree to calculate the value of an American and Euro option
 The B-S value of a Euro option is also calculated
 It is assumed that the error from the tree used to price to Euro option is the same as
the error from pricing an American option with the same tree
o Difference between B-S and Binomial Tree = estimation error i.e., error
generated from using the binomial tree
 The binomial tree valuation is not fully accurate
 Euro option value from B-S model is most accurate
 Therefore, the price of an American option is estimated to be:

## F(a) + F(bs) – F(E)

 The CVT involves using the tree to calculate difference between the Euro and
American price
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##  Forgetting early exercise opportunities in binomial tree

 Forgetting to adjust u, d and p calculations when options differ i.e. using the wrong
formula
 Forgetting B-S model adjustments for d (1) and d (2) when options differ
o Changes must be made when depending on the stock
 Stock
 Index
 Forex
 Futures
o Account for all changes!

## Alternative Procedures for constructing trees

 Rather than setting u=1/d, we can set each of the probabilities to 0.5
 Refer to page 442
 Advantage: Probabilities are always 0.5 regardless of the value of sigma or the
number of the time steps
 Disadvantage: more difficult to calculate the Greek letters as the tree is no longer
centred around stock price
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##  We have assumed that r, q, r(f), and sigma are constant

 In practiced, these variables are time-dependent and are assumed to be equal to their
forward values
o The geometry of the tree is unaffected when r and q is a function of time
o To make sigma a function of time, the length of time steps should be altered
to be inversely proportional to the variance rate

##  Oscillation reflects pricing error

 Binomial tree values eventually converge to the true value of the option as more
steps are introduced into pricing error
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Homework

Chapter 16

16.14 Would you expect the volatility of a stock index to be greater or less than the volatility
of a typical stock?

##  Volatility of stock index is less than that of a stock

 Stock index risk is diversified away when a portfolio of stocks is created
 In CAPM, there is systematic and unsystematic risk in returns of individual
stocks
 In stock indices, the idiosyncratic risk has been mostly diversified away and
only systematic risk contributes to the volatility