Implied Trinomial Trees: Autumn 2 0 0 9

A U T U M N
2 0 0 9
IMPLIED TRINOMIAL TREES
Numerical Methods in Finance (Implementing Market Models)

COMPUTATIONAL FINANCE
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©Finbarr Murphy 2007
Lecture Objectives
 Implied Trinomials
 Understand State Prices
 Understand the code to find state prices from market prices of
call and put options
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Agenda
Page
Implied Trinomial Trees 2

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Implied Trinomial Trees

 Standard or Vanilla Option Contracts traded on
exchanges such as the CBOE, contain important
information within the price
 Market expectations are implied in the price

 E.g. Implied volatility of Dec ’07 contract = 19%
 Implied volatility of Feb ’08 contract = 20.5%
 One can construct or imply a term structure of

volatilities from such information
 Better yet a volatility surface

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Volatility Surface
0.24
0.22
Volatility
0.2
0.18
0.16
5
5 4
4
3 3
2 2
1
maturity 1
Swap Duration
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 We can better price non-standard or exotic options
from this implied market expectation
 In particular, we can construct trees or lattices to

price exotic options that are consistent with standard
option prices
 We can “fit” or imply a tree such that its option value

equals the market price of the option
 Then, putting these implied trees together, we can

price exotic options
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 In our trinomial tree, we have
j=2 Ci+1,j+1
 Time steps Δti
Δx
— Where i = 1, … ,N
j=1
— Note the i subscript Ci,j Ci+1,j
Δx
 and j=0
Si , j  Se jx Δx
j=-1
Δx
j=-2
i=0 i=1 i=2

Δt1 Δt2
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 At each node, we have a state j=2

Q2,2
price Qi,j
Q1,1 Q2,1
j=1
 This is the current price of a
unit currency (one $) if a future j=0
Q1,0 Q2,0
state is reached
j=-1 Q2,-1
 It is zero if the state is not
reached j=-2 Q2,-2
i=0 i=1 i=2

 Like a zero bond but with the
added binary state
 This state price is a useful concept which we will
 utilise laterprice is a useful
This state
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 Now, we can generalise and say j=2

Q2,2
that the price of a European

Option with a strike price K j=1
Q1,1 Q2,1
and maturity NΔt is given by

Q1,0 Q2,0
j=0
 max S  K ,0QN , j
N
C  K , Nt   N, j j=-1 Q2,-1
j  N
j=-2 Q2,-2
 It is often easier to
i=0 i=1 i=2

conceptualise by considering a
simple 2-step grid as described
above
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 Now, what is the price of a call Q2,2
j=2
option if the strike price, K, is set S2,2
to SN,N-1? j=1
Q1,1 Q2,1 K=SN,N-1
S2,1 =S2,1
C  K  S N , N 1 , Nt    S N , N  S N , N 1 QN , N j=0

Q1,0 Q2,0
S2,0
j=-1 Q2,-1
S2,-1
 Or, as in our specific 2-step model
j=-2 Q2,-2
i=0 i=1 S2,-2

i=2
C  K  S 2,1 , Nt    S 2, 2  S 2,1 Q2, 2

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 We know the value of the call Q2,2
j=2
option (observing market data) S2,2
Q1,1 Q2,1 K=SN,N-1

j=1
 And we know S2,2 and the strike S2,1 =S2,1
K=S2,1 j=0
Q1,0 Q2,0
S2,0
 So, we can calculate Q2,2 j=-1 Q2,-1

S2,-1
j=-2 Q2,-2
i=0 i=1 S2,-2

i=2
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 Now, drop the strike one level so Q2,2
j=2
that K = SN,N-2 S2,2
Q1,1 Q2,1
j=1
 We know that S2,1
C  K  S N , N  2 , Nt   j=0
Q1,0 Q2,0
S2,0
K=SN,N-2
=S2,0
S N ,N  S N , N  2  QN , N  j=-1 Q2,-1
S  S N , N  2 QN , N 1
S2,-1
N , N 1 j=-2 Q2,-2
i=0 i=1 S2,-2

i=2
 Or, in our 2-step model;
C  K  S 2,0 , Nt    S 2, 2  S 2,0 Q2, 2   S 2,1  S 2,0 Q2,1

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 From the last equation, we know
Q2,2
j=2
all value except for Q2,1 which we S2,2
can easily calculate Q1,1 Q2,1

j=1
S2,1
 We can continue in this manner to
Q1,0 Q2,0 K=SN,N-2
calculate all values of QN,j j=0
S2,0 =S2,0
C  S N , j 1 , Nt    S N , j  S N , j 1 QN , j  j=-1 Q2,-1
k  j 1  S N ,k  S N , j 1 QN ,k
N S2,-1
j=-2 Q2,-2
i=0 i=1 S2,-2

i=2
 Normally, we stop at QN,0 and work
from the bottom up using put
values
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 Time for an example: Wal-Mart Near-The-Money
Puts and calls within a 4-month maturity
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 Time for an example: We’ll start with Clewlow and
Strickland Example P136
 T = 1 (year)
 S = 100
 R = 6% (interest rate)
 N = 4 (number of steps)
 Δx = 0.2524 ( σ3Δt)
 The code is short, easily understood but tricky to

implement
 We will implement step by step

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 Initialise variables and some pre-calculations:
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 Populate the stock prices in the tree
 Observe the output:

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 We don’t have market option prices for this
example so we’ll just calculate them:
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 Start top-right, work down to the middle using our
call option prices
 The tricky bit is the selection of I, j and k

 Tip: First ignore the calculations and make sure you
traverse the grid correctly

N
k  j 1
S N ,k  S N , j 1 QN ,k
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 Here are the state prices after the call options
have been used:
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 Task: Calculate the state prices for the bottom
portion of the tree
 Tips & Advice:
 Draw the grid on a page, for each calculation, note the
grid coordinates
 Replicate these coordinates with variables
 E.g.
 for i=N+1:-1:2
 for j=N+i-1:-1:N+2
 for k=j+1:N+i
 disp(sprintf('i = %d, j = %d, k = %d',i,j,k));
 end
 end
 end
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 Produces the following values:
 i = 5, j = 8, k = 9
 i = 5, j = 7, k = 8
 i = 5, j = 7, k = 9
 i = 5, j = 6, k = 7
 i = 5, j = 6, k = 8
 i = 5, j = 6, k = 9
 i = 4, j = 7, k = 8
 i = 4, j = 6, k = 7
 i = 4, j = 6, k = 8
 i = 3, j = 6, k = 7
 I.e. the coordinates required in the correct

sequence
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 Back to our specific example.
 Clearly, the available data does not easily lend

itself to a grid so we must use various techniques
such as interpolation to generate our lattice
 Look at the mid-call prices
Mid-Price Strike
1.600 42.5
0.425 45.0
 We can calculate the At-The-Money Call option

price using interpolation. E.g. Matlab code
 interp1([42.5 45], [1.6 .425], 43.32)
 Ans = 1.2146
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 Next, consider the time-steps: The analysis is on
Aug-30 2007
 Maturity is Sept 19th 2007 (third Wednesday)
 This is 20 days
 T = 20/365
 N=4
 Therefore
 dt = 5/365
 Space steps are set at σ3Δt = 0.0405

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 Very little difference to the C&S example:
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 But, the resultant stock tree is of course different
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 Using interpolation techniques, we estimate the
option price values
 Giving
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Recommended Texts
 Required/Recommended
 Clewlow, L. and Strickland, C. (1996) Implementing derivative
models, 1st ed., John Wiley and Sons Ltd.
— Chapter 5
 Additional/Useful
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A U T U M N

IMPLIED TRINOMIAL TREES

Numerical Methods in Finance (Implementing Market Models)

Implied Trinomial Trees 2

Implied Trinomial Trees

 Market expectations are implied in the price

 One can construct or imply a term structure of

volatilities from such information

 Better yet a volatility surface

Implied Trinomial Trees

Implied Trinomial Trees

 In particular, we can construct trees or lattices to

 We can “fit” or imply a tree such that its option value

 Then, putting these implied trees together, we can

Implied Trinomial Trees

i=0 i=1 i=2

Implied Trinomial Trees

 At each node, we have a state j=2

i=0 i=1 i=2

Implied Trinomial Trees

 Now, we can generalise and say j=2

that the price of a European

and maturity NΔt is given by

i=0 i=1 i=2

Implied Trinomial Trees

C  K  S N , N 1 , Nt    S N , N  S N , N 1 QN , N j=0

i=0 i=1 S2,-2

C  K  S 2,1 , Nt    S 2, 2  S 2,1 Q2, 2

Implied Trinomial Trees

Q1,1 Q2,1 K=SN,N-1

 So, we can calculate Q2,2 j=-1 Q2,-1

i=0 i=1 S2,-2

Implied Trinomial Trees

i=0 i=1 S2,-2

C  K  S 2,0 , Nt    S 2, 2  S 2,0 Q2, 2   S 2,1  S 2,0 Q2,1

Implied Trinomial Trees

can easily calculate Q1,1 Q2,1

C  S N , j 1 , Nt    S N , j  S N , j 1 QN , j  j=-1 Q2,-1

i=0 i=1 S2,-2

Implied Trinomial Trees

Implied Trinomial Trees

 The code is short, easily understood but tricky to

 We will implement step by step

Implied Trinomial Trees

Implied Trinomial Trees

 Observe the output:

Implied Trinomial Trees

Implied Trinomial Trees

 The tricky bit is the selection of I, j and k

Implied Trinomial Trees

Implied Trinomial Trees

Implied Trinomial Trees

 I.e. the coordinates required in the correct

Implied Trinomial Trees

 Clearly, the available data does not easily lend

 We can calculate the At-The-Money Call option

Implied Trinomial Trees

 Maturity is Sept 19th 2007 (third Wednesday)

 Space steps are set at σ3Δt = 0.0405

Implied Trinomial Trees

Implied Trinomial Trees

Implied Trinomial Trees