Binomial Option Pricing

Professor P. A. Spindt
 A simple example
 A stock is currently priced at $40 per
share.
 In 1 month, the stock price may
 go up by 25%, or
 go down by 12.5%.
 A simple example
 Stock price dynamics:
t = now t = now + 1 month

$40x(1+.25) = $50 up state

$40
$40x(1-.125) = $35 down state
 Call option
 A call option on this stock has a strike
price of $45
t=0 t=1
Stock Price=$50;
Call Value=$5
Stock Price=$40;
Call Value=$c
Stock Price=$35;
Call Value=$0
 A replicating portfolio
 Consider a portfolio containing  shares
of the stock and $B invested in risk-free
bonds.
 The present value (price) of this portfolio is
S + B = $40  + B
 Portfolio value
t=0 t=1

$50  + (1+r/12)B up state

$40  + B

$35+ (1+r/12)B down state

 A replicating portfolio
 This portfolio will replicate the option if
we can find a  and a B such that
$50  + (1+r/12) B = $5 Up state
and
$35  + (1+r/12) B = $0 Down state

Portfolio payoff = Option payoff

 The replicating portfolio
 Solution:
 = 1/3
 B = -35/(3(1+r/12)).

 Eg, if r = 5%, then the portfolio contains

 1/3 share of stock (current value $40/3 =
$13.33)
 partially financed by borrowing
$35/(3x1.00417) = $11.62
 The replicating portfolio
 Payoffs at maturity

up state down state

Stock Price $ 50.00 $ 35.00
1/3 Share $ 16.67 $ 11.67
Bond Repayment $ 11.67 $ 11.67
Net portfolio $ 5.00 $ -
 The replicating portfolio
 Since the the replicating portfolio has
the same payoff in all states as the call,
the two must also have the same price.
 The present value (price) of the
replicating portfolio is $13.33 - $11.62 =
$1.71.
 Therefore, c = $1.71
A general (1-period) formula

Cu − Cd SuCd −SdC u
Δ= B=
Su − Sd (1+ r)(Su −Sd )

pCu + (1− p)Cd

c = ΔS+ B =
1+ r

r −d
p=
u −d
 An observation about 
 As the time interval shrinks toward
zero, delta becomes the derivative.
Cu − Cd ∂C
Δ= →
Su − Sd ∂S
 Put option
 What about a put option with a strike
price of $45
t=0 t=1
Stock Price=$50;
Put Value=$0
Stock Price=$40;
Put Value=$p
Stock Price=$35;
Put Value=$10
 A replicating portfolio
t=0 t=1

$50  + (1+r/12)B up state

$40  + B

$35+ (1+r/12)B down state

 A replicating portfolio
 This portfolio will replicate the put if
we can find a  and a B such that
$50  + (1+r/12) B = $0 Up state
and
$35  + (1+r/12) B = $10 Down state

Portfolio payoff = Option payoff

 The replicating portfolio
 Solution:
 = -2/3
 B = 100/(3(1+r/12)).

 Eg, if r = 5%, then the portfolio contains

 short 2/3 share of stock (current value
$40x2/3 = $26.66)
 lending $100/(3x1.00417) = $33.19.
 Two Periods
Suppose two price changes are possible
during the life of the option
At each change point, the stock may go
up by Ru% or down by Rd%
 Two-Period Stock Price
Dynamics
 For example, suppose that in each of
two periods, a stocks price may rise by
3.25% or fall by 2.5%
 The stock is currently trading at $47
 At the end of two periods it may be
worth as much as $50.10 or as little as
$44.68
 Two-Period Stock Price
Dynamics
$50.10

$48.53

$47 $47.31

$45.83

$44.68
 Terminal Call Values
At expiration, a call with a strike
price of $45 will be worth: Cuu =$5.10

$Cu

$C0 Cud =$2.31

$Cd

Cdd =$0
 Two Periods
The two-period Binomial model formula
for a European call is

p2C UU + 2p(1− p)CUD + (1− p)2 C DD

C= 2
(1+ r)
 Example
TelMex
TelMex Jul
Jul 45
45 143
143 CB
CB 223//1616 --5//1616 47
3 5
47 2,703
2,703
Two
TwoPeriod
PeriodBinomial
BinomialModel
Model
Call Option Price Calculator
Call Option Price Calculator
Stock Price
Stock Price $47.00
$47.00
Exercise
ExercisePrice
Price $45.00
$45.00
Years
YearstotoMaturity
Maturity 0.08
0.08
Risk-free
Risk-freeRate
Rate(per
(perannum)
annum) 5.00%
5.00%
Ru
Ru 3.25%
3.25%
Rd
Rd -2.50%
-2.50%
pp 47.10%
47.10%
Stock
StockValue
ValueininUp
UpUpUpState
State $$50.10
50.10
Call Value in Up Up State
Call Value in Up Up State $$ 5.10
5.10
Stock
StockValue
ValueininDown
DownUp UpState
State $$47.31
47.31
Call Value in Down Up State
Call Value in Down Up State $$ 2.31
2.31
Stock
StockValue
ValueininDown
DownDown
DownState
State $$44.68
44.68
Call
CallValue
ValueininDown
DownDown
DownState
State $$ - -
Call
CallValue
Value $$ 2.28
2.28
 Estimating Ru and Rd
According to Rendleman and Barter you can
estimate Ru and Rd from the mean and
standard deviation of a stock’s returns
μt t
Ru = exp( n + σ n)−1

μt t
Rd = exp( n −σ n)−1
 Estimating Ru and Rd
In these formulas, t is the option’s time to expiration
(expressed in years) and n is the number of intervals
t is carved into

μt t
Ru = exp( n + σ n)−1

μt t
Rd = exp( n −σ n)−1
 For Example
 Consider a call option with 4 months to
run (t = .333 yrs) and
 n = 2 (the 2-period version of the
binomial model)
 For Example
 If the stock’s expected annual return is
14% and its volatility is 23%, then

Ru = exp(.14× .332 + .23 .332)−1= .1236

 For Example
 The price of a call with an exercise price of $105 on a stock
priced at $108.25 Two Period Binomial Model
Call Option Price Calculator
Stock Price $108.25
Exercise Price $105.00
Years to Maturity 0.33
Risk-free Rate (per annum) 7.00%
Ru 12.36%
Rd -6.79%
p 41.49%
Stock Value in Up Up State $ 136.66
Call Value in Up Up State $ 31.66
Stock Value in Down Up State $ 113.37
Call Value in Down Up State $ 8.37
Stock Value in Down Down State $ 94.05
Call Value in Down Down State $ -
Call Value $ 9.30
 Anders Consulting
 Focusing on the Nov and Jan options,
how do Black-Scholes prices compare
with the market prices listed in case
Exhibit 2?
 Hints:
 The risk-free rate was 7.6% and the expected
return on stocks was 14%.
 Historical Estimates: IBM = .24 & Pepsico = .38