The Binomial Method

Introduction. If I knew for sure that the value of an option at expiration

would be $X, then I could assert that the current value of the option is
exactly the current value of a payment of $X at expiration. This value is
the discounted value of the payoff. In option pricing, we assume that interest
rates are compounded continuously, so we’d write
V (S0 , t) = e−r(T −t) X
where t is the current time, S0 is the current spot price, X is the value
of the option at expiration, and r is the risk-free rate, which we assume is
constant.
Unfortunately, we do not know the value of the option at expiration. It
is a random quantity (i.e., a random variable). So, we try to model the
dynamics of the underlying and take our value of the option at expiration
to be the expected value of the payoff at expiration. So we could write, in
an abstract way,
V (S0 , t) = e−r(T −t) E[P ]
where P is the payoff function. If we have a vanilla, European option, then
we can say that P is a function of spot only. In this case the expectation
operator E[P ] is esssentially an integral of the payoff function (with spot as
the variable) against some probability density function, say µ(S, K, S0 , T −
t, r, σ). It makes sense that the probability density depends on all of the
variables indicated. (For example, if current spot S0 is far away from strike
K, the value of the option should be quite different from the case when
K = S0 . In fact the ratio SK0 is all that really matters; it is often called
“moneyness”.) So, we could write
Z ∞
V (S0 , t) = e−r(T −t)
E[P ] = P (S)µ(S, K, S0 , T − t, r, σ)dS
0
The Black-Scholes functions can be viewed this way. The continuous-time
model of the dynamics of the underlying gives rise to an explicit distribution
function. In the case of vanilla calls and puts, the associated integrals can
be evaluated.
We will see this shortly (a truly rigorous approach requires about a year
of rigorous Math prerequisites), but first we want to introduce a discrete
model that is accessible to practitioners. Rather than allowing continuous
time trading with a continuous range of underlying prices possible at each
instant of time, we consider discrete time steps and allow the underlying to
move to only two possible values at each time point. For example, starting
with spot S0 , at time t0 , we allow the values of S at t1 to be only uS0 and
dS0 , where u and d satisfy d < 1 < u. In principal, such a restriction on the
dynamics could allow for 2 possible states for S at t2 , 4 states at t2 , 8 states
at t3 , . . . , 2N states at tN . This gets to be unwieldy rather quickly. So we
will impose a requirement on u and d that guarantees that at tN there are
only N + 1 states for S.
1
 Finally, our derivation is rather brief; some might think it is incomplete.
Our purpose in developing the Binomial model 1 is mainly to provide a tool
to use in some option pricing problems. With only a little more effort, one
can develop a PDE tool that gives much more insight into the option prices.
We will see this, but not for a while.
Model for the Underlying. Starting with the spot price S at time t, we
allow it to move to either uS or dS in the time frame of length ∆t. To
guarantee that the number of states is controlled, we require the ud = 1.
This means that an up move followed by a down move leaves us at the same
place as a down move
√ followed by an√ up move, namely back at S. We may
then write u = e σ ∆t and d = e −σ ∆t . This strange way of expressing u

and d is motivated by a desire to relate what we do back to the model

∆S √
= µ∆t + σ ∆tZ
S
where Z is random. For, note the following: if we write
√ √ √
Su = uS = eσ ∆t S ≈ (1 + σ ∆t)S = S + σ ∆tS
√ √ √
Sd = dS = e−σ ∆t S ≈ (1 − σ ∆t)S = S − σ ∆tS

Then, we can say that

∆S √
= σ ∆tZ
S
where the random variable Z takes on the values 1, −1 each with some
probability (to√ be determined below). We argue that since ∆t is much
smaller than ∆t as ∆t → 0, we can drop the drift term µ∆t .
This argument is only slightly different from the one given in class where
we argued that Taylor expansions show that S1S−S 0
0
is close to log( SS10 ). We
used this approximation to replace the ∆S S in the model equation above;
exponentiated to clear the log from the equation; and argued √ that the µ
term could be dropped because ∆t was so much smaller that ∆t.
Now, starting with the current spot S0 , one can create a tree of stock
prices. At time tk there are prices Ski where 0 ≤ i ≤ k. The result of
applying d k-times is Sk0 = dk S0 ; the result of k up moves is Skk = uk S0 ; and
in general, Ski = ui dk−i S0 . For 1 ≤ i ≤ k + 1, we can construct Sk+1i = uSki
0
with Sk+1 = dSk .0

Option Price Tree and Simple European Options. In this section,

we assume that the option is a European option. The payoff is not allowed
to depend on the dynamics of the underlying, only on the value of the
underlying at expiration. So spreads of vanillas are treated, but Asian and
American options are not.
1There are many Binomial tree based methods; the model we are pursuing is the Cox-
Ross-Rubinstein (CRR) model.
2
 Now that we have to construct option prices Vki that correspond to the
stock prices Ski constructed above. We assume that 0 ≤ k ≤ N , 0 ≤ i ≤ k,
tk = t0 + k∆t (so ∆t = tNN−t0 ). With this Ski is our approximation to the
stock price at time tk following i up moves and k − i down moves and Vki will
be the approximate price of the option at time tk and stock value Ski . As
a practical matter, if one wants to estimate the option value at some other
time and stock price, then one can try to use some interpolation method.
Linear interpolation is as good as anything here.
We analyze the relationship between option values time t and time t + ∆t
under the following assumptions
• The option is part of a portfolio that is constructed to be risk-free.
• Arbitrage is not allowed.
Consider a portfolio consisting of ∆ shares of the underlying and short
one option. Its value at time t is
Π = ∆S − V
At time t + ∆t, the stock moves to either uS = Su or dS = Sd . The
option has corresponding moves to Vu or Vd , and the portfolio then moves
to either Πu or Πd . We want to find the value of ∆ that will insure that
the portfolio has no risk; that is, that Πu = Πd . Now, Πu = Πd , means
∆Su − Vu = ∆Sd − Vd . Solving for ∆ gives
Vu − Vd ∂V
∆= ≈
Su − Sd ∂S
At this stage of the development the values of V are still unknown. But, we
see how they can be used to create a risk-free portfolio (under the model).
We now consider how the risk-free portfolio must grow in a world that
does not allow arbitrage. Recall that the risk-free rate r is the annual interest
rate at which we can both earn interest on deposts and borrow money. If our
risk-free porfolio grew at a rate greater than r, say it grows at rate R > r,
then at time ∆t we could borrow (at rate r) enough to buy the porfolio, say
X, sell the portfolio at time t + ∆t for RX∆t and pay back the loan with
rX∆t and keep our profit of (R − r)X∆t > 0. This is a risk-free profit.
Since risk-free profits are not allowed in the model, we must conclude that
R ≤ r. Similarly, if the portfolio grew at a rate R < r, we could short the
portfolio and invest the proceed in a risk-free bank account and reap a profit
of (r − R)X∆t at time t + ∆t. So we have to conclude that the portfolio
grows at the rate r and, thus,
Π(t) = e−r∆t Π(t + ∆t) = e−r∆t Πu
Expressing the porfolio in terms of S and V : S∆ − V = e−r∆t (uS∆ − Vu )
gives
V = S∆ − e−r∆t (uS∆ − Vu )
= e−r∆t (∆[Ser∆t − uS] + Vu )
3
 Using the previously determined value of ∆, and algebra, we can verify
the following steps
e−r∆t
V = [(Vu − Vd )(er∆t − u) + Vu (u − d)]
u−d
e−r∆t
= [Vu (er∆t − d) + Vd (u − er∆t )]
u−d
er∆t − d u − er∆t
= e−r∆t [Vu + Vd ]
u−d u−d
= e−r∆t [Vu q + Vd (1 − q)]
where
er∆t − d
q=
u−d
Now, if d < e r∆t < u, we have that 0 < q < 1. This means that q can be
thought of as a probability measure and that the expression Vu q + Vd (1 − q)
is the expected value of the option price with respect to this probability
measure. Therefore, the equation V = e−r∆t [Vu q + Vd (1 − q)] expresses
V (t) as the discounted expected value of of V (t + ∆t) under the probability
measure q.
It is a simple matter to obtain a formula for the price of the option at
time k when the stock has price Ski . We take the discounted expectation of
i i+1
the option prices corresponding to the stock values Sk+1 and Sk+1 :
i+1
Vki = e−r∆t [Vk+i i
q + Vk+1 (1 − q)]
We start this process with the values VNi = P (Sni ) where P is the payoff
function of the option. The current price of the option will be V00 .
For European options it is not necessary to form all of the stock prices;
i , 0 ≤ i ≤ N are used.
only the final values SN
American Option Pricing. For American options, one must check at
every step of the option evaluation, whether or not it makes sense to exercise.
One exercises if the intrinsic value of the option is greater than its discounted
expected value given by the calcuations in the previous section. By intrinsic
value we mean the profit one would get by purchasing the underlying and
immediately exercising the option. For example, in the case of a call this
is S − K (assuming S > K). More generally, let’s assume that the payoff
function is P (S) where S is the spot price. The main cases of interest are
calls and puts. The formula given above for Vki has to be modified to
i+1
Vki = max{e−r∆t [Vk+i i
q + Vk+1 (1 − q)], P (Ski )}
The term P (Ski ) indicates that to price American Options, it is necessary
to have the values of Sk for all 0 ≤ k ≤ N , and 0 ≤ i ≤ k.