CHAPTER 6

OPTION PRICING

1
Outline
1. Binomial trees
2. Black-Scholes Pricing Formulas

2
Valuation of options - Binomial trees
• A useful and very popular technique for pricing
an option involves constructing a binomial tree.
• This is a diagram representing diffrent possible
paths that might be followed by the stock price
over the life of an option.

• Base on no-arbitrage arguments and a principle

of risk neutral valuation.

3
 A Simple Binomial Model

• A stock price is currently $20 🡪 Underlying asset

• In 3 months it will be either $22 or $18
• Price of a call option of this stock, T=3 months

Stock Price = $22

Stock price = $20
Stock Price = $18

4
 A Call Option
A 3-month call option on the stock has a strike price
of 21. Port has 2 positions: long delta shares +short 1
call.

Stock Price = $22

Option Price = $1
Stock price = $20
Option Price=?
Stock Price = $18
Option Price = $0

5
 Setting Up a Riskless Portfolio
• Consider the Portfolio: long Δ shares
short 1 call option

22Δ – 1
• Portfolio is riskless when 22Δ – 1 = 18Δ or
Δ = 0.25
18Δ

6
 Valuing the Portfolio
(Risk-Free Rate is 12%)

• The riskless portfolio is:

long 0.25 shares short 1 call
option
• The value of the portfolio in 3 months is 22
× 0.25 – 1 = 4.50
• The value of the portfolio today is
4.5e – 0.12×0.25 = 4.3670

7
 Valuing the Option
• The portfolio that is
long 0.25 shares short 1 option

is worth 4.367
• The value of the shares is 5.000
(= 0.25 × 20 )
• The value of the option is therefore
0.633 (= 5.000 – 4.367 )

8
 Generalization (a)
A derivative lasts for time T and is
dependent on a stock

S0u
ƒu
S0
ƒ
S0d
ƒd

9
 Generalization (b)

• Consider the portfolio that is long Δ shares and short 1

derivative

S0uΔ – ƒu

ƒu –= ƒSd0dΔ – ƒd or
• The portfolio is riskless when S0uΔS0–dΔ

10
 Generalization (c)

• Value of the portfolio at time T is

S0uΔ – ƒu
• Value of the portfolio today is (S0uΔ
– ƒu)e–rT
• Another expression for the portfolio
value today is S0Δ – f
• Hence ƒ = S0Δ – (S0uΔ –
ƒu )e–rT

11
 Generalization (d)

• Substituting for Δ we obtain

ƒ = [ pƒu + (1 – p)ƒd ]e–rT

where

12
 p as a Probability
• It is natural to interpret p and 1-p as probabilities of
up and down movements
• The value of a derivative is then its expected payoff in
a risk-neutral world discounted at the risk-free rate

S0u
p ƒu
S0
ƒ
(1 – S0d
p) ƒd

13
 Risk-Neutral Valuation
• When the probability of an up and down movements are p
and 1-p the expected stock price at time T is S0erT
• This shows that the stock price earns the risk-free rate
• Binomial trees illustrate the general result that to value a
derivative we can assume that the expected return on the
underlying asset is the risk-free rate and discount at the
risk-free rate
• This is known as using risk-neutral valuation

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 Original Example Revisited
S0u = 22
p ƒu = 1
S
• Since p is the probability
0 that gives a return on the stock
equal to the risk-freeƒ rate. We can find it from
S0d = 18
20e0.12 ×0.25 = 22p + 18(1 –(p1 )– p
which gives p = 0.6523
) ƒd = 0
• Alternatively, we can use the formula

15
Valuing the Option Using Risk-Neutral
Valuation
S0u = 22
52 3 ƒu = 1
0.6
S0
ƒ
The value of the option
0.34 is S0d = 18
–0.12×0.25
77
e (0.6523×1 + 0.3477×0) ƒd = 0
= 0.633

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 A Two-Step Example
24.2
22
• Each time step is 3 months
20 r=12%
• K=21, 19.8

18
16.2

17
 Valuing a Call Option
24.2
D
3.2
22
• Value at node B is B
e–0.12×0.25(0.6523×3.2
20 + 0.3477×0) = 2.0257
2.0257 19.8
A E
• Value 1.2823at node A is 0.0
–0.12×0.25
18
e (0.6523×2.0257 + 0.3477×0) C = 1.2823
0.0 16.2
F 0.0

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• Ex: Consider a 2-year European put with a strike
price of $52 on a stock whose current price is
$50. Suppose that there two time steps of 1
year, and in each time step the stock price either
moves up by 20% or moves down by 20%. The
risk-free rate is 5% per annum.

• u =1.2, d =0.8

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 A Put Option Example
Figure 11.7, page 246

K = 52, time step =1yr

r = 5% 72
D
0
60
B
50 1.4147 48
A E
4.1923 4
40
C
9.4636 32
F 20

20
What Happens When an Option is
American

72
D
0
60
B
50 1.4147 48
A E
5.0894 4
40
C
12.0 32
F 20

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 Delta
• Delta (Δ) is the ratio of the change in the
price of a stock option to the change in the
price of the underlying stock
• The value of Δ varies from node to node
• The number of units of stock we should hold
for each option shorted in ordered to create
a riskless portfolio.

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Problems
1. A stock price is currently $40. It is known that at
the end of 1 month, it will be either $42 or $38.
The risk-free rate is 8% per annum with
continuous compounding. What is the value of a
1-month European call option with a strike price of
$39?
2. A stock price is currently $50. It is known that at
the end of 6 months, it will be either $45 or $55.
The risk-free rate is 10% per annum with
continuous compounding. What are the values of
a 6-month European call option and a 6-month
European put with a strike price of $50? Verify
that the European call and European put prices
satisfy put-call parity.
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3. A stock price is currently $100. Over
each of the next two 6-month periods it is
expected to go up by 10% or down by
10%. The risk-free rate is 8% per annum
with continuous compounding. What is
the value of a 1-year European call
option with a strike price of $100?
4. A stock price is currently $50. Over each
of the next two-3month periods it is
expected to go up by 6% or down by 5%.
The risk-free interest rate is 5% per
annum with continuous compounding.
What is the value of a 6-month European
call option with a strike price of $51?
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5. A stock price is currently $80. It is known
that at the end of 4 months it will be either
$75 or $85. The risk-free rate is 5% per
annum with continuous compounding.
What is the value of a 4-month European
put option with a strike price of $80.
6. A stock price is currently $40. It is known
that at the end of 3 months it will be either
$45 or $35. The risk-free rate is 8% per
annum with continuous compounding.
What is the value of a 3-month European
put option with a strike price of $40?
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7. A stock price is currently $40. Over each
of the next two 3-month periods, it is
expected to go up by 10% or down by
10%. The risk-free rate is 12% per annum
with continuous compounding. What is the
value of a 6-month European put option
with a strike price of $42?

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The Stock Price Assumption

• Consider a stock whose price is S

• In a short period of time of length Δt, the
return on the stock is normally distributed:

where μ is expected return and σ is

volatility

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 The Expected Return
• The expected value of the stock price is S0eμT
• The expected return on the stock is
● μ – σ2/2 not μ

● This is because

● are not the same

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The Black-Scholes Formulas
(See chapter 13, pages 291-293)

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 The N(x) Function
• N(x) is the cumulative probability distribution
function for a standardized normal distribution
• N(x) is the probability that a normally
distributed variable with a mean of zero and a
standard deviation of 1 is less than x
• NORMSDIST in Excel

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Example

31
Example

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