Introduction to Binomial Option Pricing

Binomial option pricing enables us to determine the price

of an option, given the characteristics of the stock or other underlying asset

The binomial option pricing model assumes that the price

of the underlying asset follows a binomial distribution that is, the asset price in each period can move only up or down by a specified amount

A One-Period Binomial Tree

Example
Consider a European call option on the stock of XYZ XYZ does not pay dividends, and its current price is 100 The continuously compounded risk-free interest rate is 6% The following figure depicts possible stock prices over 1 year,

i.e., a binomial tree p S1=125 (at t=1) S0= 100 (at t=0) 1-p S1=80

A One-Period Binomial Tree

Assuming a scenario of ATM European call with a

strike price X of Rs 100 and time to expiry of 1 year. We know the value of the call is Max(S-X, 0).
If price moves up to 125, payoff will be 25, is it moves to

80, payoff will be 0. We assume 6% as risk free rate.

A One-Period Binomial Tree

To value the Call we need to find the expected value of

stock and expected value of the call at t=1 and then discount it to value at t=0. To find expected value of stock we need the probabilities of both the branches of the binomial model. Assume the probability of upward movement as p, then the probability of downward movement will automatically be (1-p).

A One-Period Binomial Tree

We now analyze three different scenarios for three different

investors A,B and C, an optimist, realist and a pessimist respectively.

Investor A, an optimist believes that probability of

upside movement is .9 and downward is therefore .1. Expected value of the stock(at t=1) will be .9*125 + .1*80=Rs 120.80 Expected value of the call at t=1 will be 120.80-100= Rs 20.80 i.e. Value of call today will be 20.80/1.06=Rs 19.62

A One-Period Binomial Tree

The above value of 19.62 provides an arbitrage opportunity,

with the following steps:

At t=0

Buy 5 shares = -5*100 = -500 Write 9 calls = 9*19.62 = 176.58 Cash flow at t=0 = Rs -323.42 Portfolio as above can be set up by borrowing at 6%, therefore the total liability would be 1.06*323.42 = 342.83

A One-Period Binomial Tree

Example
If we look at the below diagram cash inflow in both the cases

will be Rs 400 which is greater then the liability of Rs 342.83. Hence, there is an opportunity of riskless profit of
400-342.83= Rs 57.17

S0= 100 (at t=0)

1-p

S1=125 (at t=1) 5 shares 625 S1=80 400

9 calls Total -225 400 400

A One-Period Binomial Tree

If we do similar analysis with Investor B who is realist

and assumes both upward and downward probability of .5 and Investor C who is a pessimist and assumes upward probability as .1 and downward probability as .9, we find there is always an opportunity for the arbitrageur.

A One-Period Binomial Tree

Let us see the case of Investor C (p=.1):
Expected value of the stock (at t=1) =

.1*125+.9*80=Rs 84.50 Expected value of the call at t=1 = Max(84.5-100,0)=0 According to investor C, the value of the call is 0 and therefore, he would write a call if someone offers him as low as Rs 1.

A One-Period Binomial Tree

. Arbitrageur will take following actions in such a situation

Short sell 5 shares = +5*100= 500 Buy 9 calls + -9*1=-9 Total Cash flow at t=0 =+Rs 491 He invests Rs 491 at 6% to get Rs 520.46 at maturity At maturity his liability will be Case 1/2: Price moves to 125/80: Buy 5 shares @ 125 = -625/-400 Sell 9 Calls (125-100=25) = 225/0 Total Cash outflow = -400 In both the cases outflow is -400 and inflow is Rs 520.46, which gives a profit of Rs 120.46

A One-Period Binomial Tree

Such arbitrage opportunity cannot exist in a

competitive world Possible ways that all the investors agree to single price of the call option are: 1: Use of different discount rate (rather than a common 6%) so that it leads to same value of the call option 2: They agree on the same future expected value of the stock, implying that they abandon their individual estimates of upside and downside movement of stock price.

Risk Neutral Valuation

Under binomial approach if the risk neutral probability of

the upward movement is p with a gain of u% and probability of downward movement is (1-p) with a loss of d%, then the expected return must be equal risk free rate of return. Therefore: P*u + (1-p)*d=r i.e. p=(r-d)/(u-d)

If the return were to be continuously compounded, the risk neutral probabilities would be given by the equation P= (e rt -(1-d)/ (u + d))

Risk Neutral Valuation

E.g.: In our case risk free rate is given as 6% with u=25% and d=(-20%)
P= (r-d)/(u-d) = (6-(-20)/(25-(-20) = .5778 =57.78% Value of the call = .5778*25 + .4222*0= Rs 14.44 The present value of the call = 14.44/1.06 = Rs 13.63

Risk Neutral Valuation

At Rs 13.63 we can see that there is no arbitrage opportunity. Cash flow at T=0 Short sell 5 shares +5*100 = 500 Buy 9 calls = -9*13.63= -12.67 Cash flow= +Rs 377.33
The arbitrageur invests the sum at risk free rate of 6% and realize Rs 400 at the end of one year, which would be exactly equal to the outflow at the end of one year. Hence no arbitrage opportunity.

Equivalent Portfolio Approach

Equivalent Portfolio: How do we arrive the figure of 5 shares and 9 calls as we have been using for showing arbitrage? Assume we write N call options for each share. For the two possible scenarios we set the value of the portfolio of long one share and short on N call equal. This implies that the portfolio will realize the same value irrespective of the price scenario, hence making it independent of the opinion of individual investor. 1.e. (125-25*N)=80; N=1.80

i.e. For each share we write 1.80 calls, which is similar to writing 9 calls for 5 shares.

Equivalent Portfolio Approach

Value of call option:
The value of one share and 1.8 calls would have same future value of Rs 80 after one year. The investment in such a portfolio must yield a return which must be equal to risk free rate. i.e.: (100-1.8*c) * 1.06= 80 For continuous compounding equation is: (100 1.8*c) * e.06t = 80

C= Rs 13.63, which is same as before. From the above equation we can see that we do not have any component of underlying asset price. It means?????

Equivalent Portfolio Approach

Value of call option:
The call price does not tell anything about the future price behavior of the underlying stock.

Binomial Model for Put Pricing

We set up a portfolio of long on one share and M puts

with X=100. When price moves to Rs 125, put is worthless when it moves to 80, value of the portfolio will be 80 + 20*M.
Equating the final values: 80 + 20*M = 125 i.e. M= 2.25 Value of the portfolio of one share and 2.25 puts will =

(100 + 2.25 p) * 1.06 =125 i.e. p = Rs 7.97

Binomial Model for Put Pricing

Using Risk neutral valuation approach and using the

same probabilities as for call we get .5777 * 0 + .4223 * 20 = Rs 8.45 Discounting to present: 8.45/1.06 = Rs 7.97

We can also use Put-call parity relation to value put P=c-S + PV of X 13.63 100 + 100/1.06 = Rs 7.97

Extension to Two Periods

Assume two periods, each one year long, with

the stock either rising or falling by 33.33% in each period

21

Extension to Two Periods (contd)

$133.33 (UU) $100 $75 $50

$66.67 (UD = DU) $33.33 (DD)

Today

One Year Later

Two Years Later

22

Extension to Two Periods (contd)

$58.33 (UU)

$34.72
$20.66 $0 $0 (DD)

$0 (UD = DU)

Today

One Year Later

Two Years Later

23

Extension to Two Periods (contd)

Suppose there is a 65.78% probability that the

call is worth $58.33 and a 34.22% probability that the call is worthless

(0.6578 $58.33) (0.3422 $0) $38.37 $38.37 / 1.1052 $34.72

24

Extension to Two Periods (contd)

There is a 65.78% probability that the call is

worth $34.72 in one year and a 34.22% probability that the call is worthless in one year
The expected value of the call in one year is:

(0.6578 $34.72) (0.3422 $0) $22.84 $22.84 / 1.1052 $20.66

25

Factors Affecting the Option Price

Price of the underlying asset
The exercise price Time left for expiration

Volatility
The current interest rate, the risk free rate r The benefit that would accrue for holding the asset

rather than an option.

Assignment
Check how valuation of American option (Both Call

and Put) is different from valuation of European Option using Binomial pricing model?
Explain the Binomial model for Currency Option and

Index Option?