Option Pricing Using Binomial Model and

Cox-Ross-Rubinstein (CRR) Model

Arun Kumar

IIT Ropar

January 31, 2024

 Outline

1 Option pricing using delta hedging

2 Option pricing using underlying and risk free asset

3 Risk neutral pricing

4 Two-period Binomial model

5 n-Period Binomial model

6 Cox-Ross-Rubinstein (CRR) model

7 American Option

8 The Greeks

9 References
 What is an equity option ?

Definition (Equity option)

An equity option is a contract which conveys to its holder the right, but not the
obligation, to buy or sell shares of the underlying security at a specified price on or
before a Specified date. This right is granted by the seller of the option.
• Buy = Call option. Sell = Put option
• On/before: American. Only on expiration: European
• Specified price = Strike or exercise price
• Specified date = Maturity or expiration date
• Buyer = holder = long position
• Seller = writer = short position

Example (European-style put option)

An European-style XYZ May 60 put entitles the buyer to sell 100 shares of XYZ Corp.
common stock at $60 per share at the expiration date in May.
One-Period Binomial Model
 Delta hedging

Why hedging ?
• Buying a stock is a risky investment.
• Buying a call option on that stock is also risky.
• Combining the stock with the option can produce an investment that is risk free.

Delta hedging

The number of units of the stock required per option is known as the ∆ (Delta) of the
stock and taking these positions to create a risk-free investment is known as Delta
Hedging.
 Arbitrage

Definition (Arbitrage)
The simultaneous buying and selling of a security at two different prices in two different
markets, resulting in profits without risk. Perfectly efficient markets present no arbitrage
opportunities. Perfectly efficient markets seldom exist, but, arbitrage opportunities are
often precluded because of transactions costs.

Example
As a hypothetical example, if Infosys stock trades at Rs 790 on the National Stock
Exchange (NSE) and at Rs 800 on the Bombay Stock Exchange (BSE), an investor
could guarantee a profit by purchasing the stock on the NSE and simultaneously
selling the same amount of stock on the BSE.
 Payoffs from equity and call option

• Consider an equity with price S at time 0.

• Let the price will be uS under up movement and dS under down movement.
• Suppose there is an European call option with strike price K with expiry at time 1.
• Note that call option payoff will be (uS − K )+ in up state and (dS − K )+ in down
state at time 1.
uS (uS − K )+ = cu

p p

S c

(1 (1
−p −p
) )
dS (dS − K )+ = cd

t=0 t=1 t=0 t=1

 Portfolio of writing one call and buying ∆ share of equity

Suppose that we buy ∆ units of the stock and sell one call at time t = 0. The portfolio
value will be ∆uS − (uS − K )+ if equity price moves up and ∆dS − (dS − K )+ if
equity price moves down at time t = 1.

∆uS − cu
p

∆S − c

(1 − p)
∆dS − cd

t=0 t=1
 Option pricing

• To make this portfolio risk free, it is necessary to choose ∆uS − cu = ∆dS − cd ,

cu −cd
i.e. ∆ = S(u−d) .
• Further, if r is the interest rate for one period, we should have

∆dS − cd ∆uS − cu
∆S − c = = ,
1+r 1+r
which implies after substitution of value of ∆
 
1 1+r −d u−1−r
c= cu + cd
1+r u−d u−d
1
= (p̃cu + (1 − p̃)cd ), (1)
1+r
(1+r −d)
where p̃ = (u−d)
.
• If c is not so, there will be an arbitrage opportunity.
• Interestingly in option price formula the probability term p doesn’t appear.
 An example

• Suppose the current price of the underlying stock is 100 and at the end of three
months it has either risen to 175 or has fallen to 75.
• Consider an at-the-money call option on this stock with a strike price of 100 with
expiry after 3 months.
• Suppose for 3-months risk free rate of interest is 25% (or 100% annual).

Find u, d, r and p̃ ?
u = 1.75, d = .75, r = .25, p̃ = 1/2.

What are the values of cu and cd ?

cu = (uS − K )+ = max(uS − K , 0) = max(75, 0) = 75.
cd = (dS − K )+ = max(dS − K , 0) = max(−25, 0) = 0.

What is ∆ ?
cu −cd
∆ = S(u−d) = 3/4.

What is option price c ?

1
c = 1+r (p̃cu + (1 − p̃)cd ) = 30.
 Example

• Consider again the same example, where the price of the underlying stock is 100
initially and at the end of 3 months it has either risen to 175 or fallen to 75.
• Consider an European call option of strike price 100.
• the payoff of the call option in up state is 75 and payoff in the down state is 0 and
the option will not be exercised.
• Consider buying ∆ unit of the stock and investing B units of fund at risk free
interest rate of 25% for 3-months (or 100% annualized).
175∆ + (1 + 1/4)B
p

100∆ + B

(1 − p)
75∆ + (1 + 1/4)B

t=0 t=1
 Replicating portfolio

175∆ + (1 + 1/4)B 75
p p

100∆ + B c

(1 − p) (1 − p)
75∆ + (1 + 1/4)B 0

t=0 t=1 t=0 t=1

Cash-flows from portfolio Cash-flows from call option

 Solving for ∆ and B

• To replicate the cash-flows from option, we should have 175∆ + (1 + 1/4)B = 75

and 75∆ + (1 + 1/4)B = 0, which implies ∆ = 3/4 and B = −45.

• Thus option can be replicated by borrowing 45 and buying 3/4 units of the stock.

• The value of this portfolio at time 0 is 100 × 3/4 − 45 = 30.

• Due to no-arbitrage principle the portfolio that replicates the call option will have
same price as the call itself that is c = ∆S + B.

• Hence the price of the call is c = 30 which is same as the previous case.
 If c ̸= ∆S + B, we have arbitrage

Suppose c = 25, then we consider the following portfolio at t = 0. This means

∆S + B > c.
• Short sell 3/4 shares and generate 75.

• Buy one call option with 25.

• Invest the remaining 50 in bank. This is a zero investment portfolio.

If there is an up movement, at maturity, we will have the following:
• Exercise the call option and receive one share by paying Rs 100. Return 3/4
shares which were short sell. Sell the remaining 1/4 shares with market price Rs
175/4 = 43.75.

• The investment in the bank will be 50(1 + .25) = 62.5.

• Total payoff at maturity = 62.5 + 43.75 − 100 = 6.25.

 If c ̸= ∆S + B, we have arbitrage contd...

If there is a down movement, at maturity, we will have

• The call option is worthless.

• Buy the 3/4 shares from the market with amount 75 × 3/4 = 56.25 and return to
the person from whom the equity was borrowed for short sell.

• The investment in the bank will be 50(1 + .25) = 62.5.

• Total payoff at maturity = 62.5 − 56.25 = 6.25.

 If c > ∆S + B, we have arbitrage

Suppose c = 40, then we consider the following portfolio at t = 0. This means

c > ∆S + B.
• Sell the call option and receive 40.

• Buy 3/4 shares by paying Rs 75.

• Borrow the remaining 35 from the bank with interest rate 0.25 for the period. This
is a zero investment portfolio.
If there is an up movement, at maturity, we will have the following:
• The call option will be exercised and we give the 3/4 share we bought at strike
price 100. Further, we buy the remaining 1/4 shares from the market with price
175/4 = 43.75. In this process, we recive the strike price of the option, which is
100.

• The loan from the bank will be 35(1 + .25) = 43.75.

• Total payoff at maturity = 100 − 43.75 − 43.75 = 12.5, which is an arbitrage

opportunity.

• Similarly for the down movement.

 Risk neutral pricing

• From earlier discussion, we have

1
c= (p̃cu + (1 − p̃)cd ),
1+r
(1+r −d)
where p̃ = (u−d)
.

• Here p̃ can be interpreted as probability if d < 1 + r < u.

• Here the value of the call option is the present value of the weighted average of
the call at maturity.

• The value of the call is present value of p̃cu + (1 − p̃)cd and is valued as if this
payoff was risk-free.

Risk-neutral probability
The risk-neutral probability is that probability under which expected returns on all the
model’s assets are the same.
 Dividend yield and continuous compounding

Dividend yield
Suppose the equity pays a dividend with dividend yield q for the period. Then we
calculate the risk-neutral probabilities as follows:

p̃uS + (1 − p̃)dS = (1 + r − q)S,

which implies
1 + (r − q) − d
p̃ = .
u−d

Continuous compounding
For continuous compounding, the risk neutral probability become for no-dividend

(er − d)
p̃ = .
(u − d)

Continuous compounding and dividend

If there is a dividend, for continuous compounding, the risk neutral probability is

(er −q − d)
p̃ = .
(u − d)
 d <1+r <u

In a one period Binomial model, we always have d < 1 + r < u, otherwise there will be
an arbitrage opportunity.
Proof.
• Suppose d ≥ 1 + r , this mean in up and down moment both equity return is
higher than the risk free rate.
• Thus, we buy the equity after borrowing S0 from bank.
• After one period total payoff will be more than or equal to dS0 − (1 + r )S0 , which
is a non-negative quantity.
• Hence d ≥ 1 + r leads to an arbitrage opportunity, which is not possible in
efficient markets.
• Similarly, by doing short selling, we prove that 1 + r ≥ u is not possible.

Remark
The no-arbitrage condition for continuous compounding for a dividend paying stock will
be
d < er −q < u.
Example
The current price of a certain non-dividend-paying stock is $100 per share. Suppose
the price of this stock is modeled at the end of a quarter year using a one-period
binomial tree under the assumption that the stock price can either increase by 4%, or
decrease by 2%.The continuously compounded risk-free interest rate is 3%. What is
the price of a three-month, at-the-money European call option on the above stock ?
Solution: We have the following
• r = 0.03/4 = 0.0075.
• u = 1.04 and d = 0.98.
• S = 100 and K = 100.
• cu = 4 and cd = 0.
• The risk neutral probability is p̃ = e.0075 −0.98
1.04−0.98
= 0.4588.
• Thus option price c = e−.0075 (0.4588 × 4) = 1.82149.
 Equivalent Martingale Measure (EMM)

Equivalent Martingale Measure (EMM)

A common method for pricing an asset is to use a risk-neutral or an equivalent
martingale measure (EMM). The EMM is convenient because all asset prices are
simply an expectation of the payoff.

Definition (EMM)
The probability measure Q is an EMM of P if St is a Q-martingale, that is

EQ ST = S0

and Q is equivalent to P,
P(ω) > 0 ⇐⇒ Q(ω) > 0
for all elementary events ω ∈ Ω.
 How to find risk neutral probabilities

Under risk neutral probabilities the discounted value of expected cash flows is equal to
the actual value of the underlying asset.
Example (Revisiting the example)
175 75
p̃ p̃

100 c

(1 (1
− p̃) − p̃)
75 0
Stock cash-flows Option cash-flows

• Under risk neutral probabilities the expected value of the stock at the end of period
is 175p̃ + 75(1 − p̃).
• So the expected present value is 175p̃+75(1−p̃)
1+1/4
.
• This is equal to the actual value of the stock that is 100, which implies p̃ = 1/2.
• Thus option value is 75∗1/2+0∗1/2
1+1/4
= 30.
Two-Period Binomial Model
 Two-period Binomial model

• The one-period model is extended by a two-period model.

• The value of the stock after two periods when both movements are up will be
u 2 S = Suu and it will be d 2 S = Sdd if both movements are down.
• If the stock first went up and then went down or it first went down and then went
up, it will be udS = Sud = Sdu .

Suu
p

Su
p (1
− p)
S Sud = Sdu
(1 p
−
p)
Sd

(1 −
p)
Sdd
 Example

• Consider the earlier discussed example.

• We have u = 1.75, d = 0.75, S = 100, K = 100, r = 100% or r = 1/4 for
3-months.

306.25
p

175
p (1
−
p)
100 131.25
(1 p
−
p)
75
(1
−
p)
56.25
 Finding value of call at intermediate steps

206.25
p̃

cu
p̃ (1
−
p̃)
c 31.25
(1 p̃
−
p̃)
cd

(1
−
p̃)
0

• The value of the call at the intermediate nodes can be found by using
delta hedging method or risk free rate and underlying asset method or by using
risk neutral valuation method.
• The risk neutral method is simple because the node probabilities are same for
different periods.
• Hence cu = 0.5×206.25+0.5×31.25 = 95
1+1/4
• cd = 0.5×31.25+0.5×0
1+1/4
= 12.5
 Finding value of call at time 0

206.25

0 .5

95
5
0. 0.5

c 31.25

0.5 0.5

12.5

0 .5
0

• Again using the similar steps as earlier, we can find the no-arbitrage price of call
option.
• c = 0.5×95+0.5×12.5 = 43.
1+1/4
• Alternatively, c = 0.5×0.5×206.25+2×0.5×0.5×31.25+0.5×0.5×0
(1+1/4)2
= 43.
 Converting into formula

(Suu − K )+
p̃

cu
p̃ (1
−
p̃)
c (Sud − K )+
(1 p̃
−
p̃)
cd
(1
−
p̃)
(Sdd − K )+

p̃2 (Suu − K )+ + 2 × p̃(1 − p̃)(Sud − K )+ + (1 − p̃)2 (Sdd − K )+

c=
(1 + r )2
n-Period Binomial Model
 n-period Binomial model

Revisiting Two-period Binomial model

We know that

p̃2 (Suu − K )+ + 2 × p̃(1 − p̃)(Sud − K )+ + (1 − p̃)2 (Sdd − K )+

c=
(1 + r )2
2
2
p̃ (1 − p̃) (Suu − K ) + 21 × p̃(1 − p̃)(Sud − K )+ + 20 p̃0 (1 − p̃)2 (Sdd − K )+
0 +



2
=
(1 + r )2
2  
1 X 2 i  +
= 2
p̃ (1 − p̃)2−i u i d (2−i) S − K
(1 + r ) i
i=0

n-period call option price

Thus the two-period option price formula can be easily generalized to n-period formula
n  
1 X n i  +
c= n
p̃ (1 − p̃)n−i u i d (n−i) S − K ,
(1 + r ) i
i=0

1+r −d
where p̃ = u−d
.
Cox-Ross-Rubinstein (CRR) model
 CRR model

Model setup
• CRR model is based on the assumption of a binomial model.
• It can be interpreted as a numerical method to solve the Black-Scholes equation.
• we discretize time and consider points in time such that
t0 = 0, t1 = ∆, t2 = 2∆, ..., tn = n∆ = T with ∆ = Tn .
• For large n, the option price from CRR model and Black-Scholes model will be
approximately same.
• By choosing

√
√
1 (er ∆ − d) 1 1 1 ∆
u = eσ ∆
, d= , p̃ = ≈ + (r − σ 2 ) ,
u (u − d) 2 2 2 σ

in Binomial model, we get the CRR model, where σ is volatility term in the model.
 A working example

Table: Call option features

Current stock price S 230.00

Exercise price K 210.00
Time to maturity T 0.50
Volatility σ 0.25
Risk free rate r 0.04545
Cost of carry b 0.04545
Time steps n 5
Option type European call

√ √
• We have ∆ = T /n = 0.1, u = eσ ∆ = e0.25 0.1 = 1.0823, and
d = 1/u = 0.9234.
• Given the current stock price S = 230 the stock can either increase to
Su = uS = 248.92 or decrease to Sd = dS = S/u = 212.52.
• After the second time step, we have Suu = uSu = 269.40 , Sud = Sdu = 230, and
Sdd = 196.36 and so on. At maturity, after 5 time steps, the stock price can take
the following six values Suuuuu = u 5 S = 341.51, Suuuud = u 4 dS = u 3 S = 291.56,
. . . , Sddddd = S/u 5 = 154.90.
 Equity price evolution under CRR model

341.51

315.55

291.56 291.57

269.40 269.4

248.92 248.92 248.92

230.00 230.00 230.00

212.52 212.52 212.52

196.36 196.36

181.44 181.44

167.65

154.90
 Option value at different nodes
We have p̃ = 0.50898 and r = 0.04545, hence
0.50898 × 131.51 + (1 − 0.50898) × 81.57
cuuuu =
e0.04545×0.1
0.50898 × 131.51 + (1 − 0.50898) × 81.57
≈ = 106.50
1 + 0.04545 × 0.1

131.51
cuuuu

cuuu 81.57

cuu cuuud

cu cuud 38.92

c cud cuudd

cd cudd 2.52

cdd cuddd

cddd 0

cdddd

0
 Dividend paying stock

• If stock dividend yield is q, then

√
√
1 (e(r −q)∆ − d) 1 1 1 ∆
u = eσ ∆
, d= , p̃ = ≈ + ((r − q) − σ 2 )
u (u − d) 2 2 2 σ
√
1 1 1 ∆
= + (b − σ 2 ) ,
2 2 2 σ
where b is called cost of carry for equity.
• Note that, we will still discount by er ∆ ≈ (1 + r ∆) for small ∆.

Table: Call option features

Current stock price S 230.00

Exercise price K 210.00
Time to maturity T 0.50
Volatility σ 0.25
Risk free rate r 0.04545
Cost of carry b 0.02545
Time steps n 5
Option type European call
 Option value at different nodes
We have p̃ = 0.49633 and r = 0.04545, hence
0.49633 × 131.51 + (1 − 0.49633) × 81.57
cuuuu = = 105.87.
1 + 0.04545 × 0.1

library(fOptions)
CRRTree = BinomialTreeOption(TypeFlag = ”ce”, S = 230, X = 210,Time = .5, r =
0.04545, b = 0.02545, sigma = 0.25, n = 5);
BinomialTreePlot(CRRTree, dy = 1, cex = 0.8, ylim = c(-6, 7),xlab = ”n”, ylab = ”Option
Value”)
 Infosys Option Price

library(quantmod)
library(fOptions)
INFY = getSymbols(’INFY.NS’,src=’yahoo’, from = ”2017-01-01”)
INFY = INFY.NS[,6]
INFY.rets = diff(log(INFY))[-1]
INFY.sd = sd(INFY.rets)*sqrt(252)
S = as.numeric(INFY.NS[nrow(INFY.NS),4])
X= 1160; T = 28/365; r = .0631; b= r; sigma = INFY.sd; n=100
CRRBinomialTreeOption(TypeFlag = ”ce”, S = S, X = X,Time = T, r = r, b = b, sigma =
sigma, n = n)
 European put option under Binomial model

Example
Suppose we have a 2 year European put with K = Rs 52 and S = Rs 50. Suppose we
consider 2 time steps each of duration 1 year, in which the stock goes up or down by
20%. Suppose risk free rate r = 0.05. We have

72
p̃

60
p̃
(1
−
p̃)
50 48
p̃
(1
−
p̃)
40

(1
−
p̃)
32
 Example of European put option contd...
The risk neutral probability

1+r −d 1 + .05 − 0.8

p̃ = = = 0.625.
u−d 1.2 − 0.8
The put option payoff are as follows under the Binomial model

0
p̃

cu
p̃
(1
−
p̃)
c 4
p̃
(1
−
p̃)
cd

(1
−
p̃)
20

We get cu = 1.429, cd = 9.524 and put option price c = 4.252.

American Options
 American option

• An American style option allows the buyer to exercise the option at any time up
to the expiration time (maturity).

• However an European style option can only be exercised at maturity.

• American options could be call option or put options.

• Although it might seem that, because of its additional flexibility, the American
style call option would be worth more, however the two style call options
without any dividend on underlying asset have identical worth.

• The American and European style put options have different worth.
 American call worth is same as European call

Proposition
For a non-dividend paying stock, one should not exercise an American call option
before its expiration time T .

Proof.
• Suppose the current price of the stock is S and we have the American call option.
• The time to expire of the option is t from now.
• If we exercise the option at this moment, we will realize the amount S − K .
• However consider the following strategy instead of exercising the option.
i Keep the call option.
ii Short sell the stock and receive amount S and put it in the bank which will give Sert at
maturity.
iii At maturity, we will have
Sert − K

if ST ≥ K
Sert − ST if ST ≤ K ,
which is larger than (S − K )ert in both the cases and hence their is no benefit in
exercising the American call option before maturity.
• Thus American call and European call options will have the same price for a
non-dividend paying stock.
 Pricing American put option using Binomial model

Example
Suppose we have a 2 year American put option with K = Rs 52 and S = Rs 50.
Suppose we consider 2 time steps each of duration 1 year, in which the stock goes up
or down by 20%. Suppose risk free rate r = 0.05. We have

72
p̃

60
p̃
(1
−
p̃)
50 48
p̃
(1
−
p̃)
40

(1
−
p̃)
32
 Pricing American put option contd...

The risk neutral probability

1+r −d 1 + .05 − 0.8

p̃ = = = 0.625.
u−d 1.2 − 0.8
The put option payoff are as follows under the Binomial model

0
p̃

cu
p̃
(1
−
p̃)
c 4
p̃
(1
−
p̃)
cd

(1
−
p̃)
20
 Pricing American put contd...

• We have
 
0.625 × 0 + 0.375 × 4
c̃u = max{K −uS, cu } = max −8, = max{−8, 1.429} = 1.429.
1.05
• Further,
 
0.625 × 4 + 0.375 × 20
c̃d = max{K −dS, cd } = max 12, = max{12, 9.524} = 12.
1.05
• Thus American put option price will be
 
0.625 × 1.429 + 0.375 × 12
put price = max 2, = max{2, 5.136} = 5.136.
1.05
• Note that American style put option price is higher than the European style put
option price.
Greeks under CRR Model
Influential Greeks
 Greeks

Greeks
The option price sensitivities to different input parameters are called “Greeks”. Greeks
are mostly used for hedging purposes. The most important Greek is the Delta.
Hedging an option with a Delta is called delta hedging.
1 The Delta of a derivative security denoted by ∆ is defined as the rate of change of
its price with respect to the price of the underlying asset. If the option price is C,
then ∆ = ∂C ∂S
.

2 The second derivative of the call option with respect to the price of the stock is
2
called the Gamma of the call option and is given by Γ = ∂∂SC2 .

3 The rate of change of the price of the call option with respect to time to maturity is
called Theta and denoted by Θ = ∂C ∂T
.
 Estimating Greeks under CRR model
The prices look like the following under two period CRR model

Suu

Su

S Sud = Sdu = S

Sd

Sdd

The option price at different nodes look like the following

cuu
cu
c cud
cd
cdd
 Greeks Calculations

1. The ∆ is given by
cu − cd cu − cd
∆= = .
Su − Sd S(u − d)
2. We calculate Γ as follows:
cuu − cud cud − cdd
Γ2 = , Γ1 = ,
Suu − S S − Sdd

and the change in the underlying is

h = 12 (Suu + S) − 21 (Sdd + S) = 21 (Suu − Sdd ). The Gamma is

Γ2 − Γ1
Γ= .
h
3. The Θ is given by
cud − c
Θ= .
2∆t
 Find the Greeks ∆, Γ and Θ

Table: Call option features

Current stock price S 230.00

Exercise price K 210.00
Time to maturity T 0.20
Volatility σ 0.25
Risk free rate r 0.05
Cost of carry b 0.05
Time steps n 2
Option type European call

√ √
• We have ∆t = T /n = 0.1, u = eσ ∆ = e0.25 0.1 = 1.0823, and
d = 1/u = 0.9234.
• Given the current stock price S = 230 the stock can either increase to
Su = uS = 248.92 or decrease to Sd = dS = S/u = 212.52.
• After the second time step, we have Suu = uSu = 269.40 , Sud = Sdu = 230, and
Sdd = 196.36.
• Further p̃ = 0.50898.
 The Tree under CRR model
The prices look like the following under two period CRR model

268.40
248.92
230 230
212.52
196.36

The option price at different nodes look like the following

58.40
cu

c 20
cd

0
 Example contd...

We have
58.40 × 0.50898 + 20 × (1 − 0.50898)
cu = = 39.35.
1 + .05 × 0.1
Similarly
20 × 0.50898 + 0 × (1 − 0.50898)
cd = = 10.13.
1 + .05 × 0.1
Further,
39.35 × 0.50898 + 10.13 × (1 − 0.50898)
c= = 24.88.
1 + .05 × 0.1
 Example contd...

• Thus
cu − cd 39.35 − 10.13
∆= = = 0.8027.
Su − Sd 248.92 − 212.52
• Further,
cuu − cud 58.40 − 20
Γ2 = = = 1.
Suu − S 268.40 − 230
and
cud − cdd 20
Γ1 = = = 0.5945,
S − Sdd 230 − 196.36
also h = (268.40 − 196.36)/2 = 36.02. Thus Γ = (1 − 0.5945)/36.02 = 0.0113.
• Moreover,
c −c 20 − 24.88
Θ = ud = = −24.4(Annual).
2∆t 2 × 0.1
Alternatively, the daily theta is Θ = −24.4/365 = −0.066849315. This mean
each passing day the value of option go down by 0.0668 approximately assuming
everything else is same.
Bermudan options
 Bermudan Option

• Bermudan options take an intermediate place between American and European

options.

• American options can be exercised at any time, while, the European can be
exercised only at maturity.

• A Bermudan option has fixed set of dates at which the option can be exercised,
e.g., annually, quarterly, or monthly.
 Pricing Bermudan Option

Table: Bermudan put option features

Current stock price S 230.00

Exercise price K 250.00
Time to maturity T 0.30
Volatility σ 0.25
Risk free rate r 0.05
Time steps n 3
Exercise Times At t = 0.10, 0.30
Option type Bermudan put

√ √
• We have ∆t = T /n = 0.1, u = eσ ∆ = e0.25 0.1 = 1.0823, and
d = 1/u = 0.9234.
• Given the current stock price S = 230 the stock can either increase to
Su = uS = 248.92 or decrease to Sd = dS = S/u = 212.52.
• Further p̃ = e0.05×0.1 −0.9234 1.005013−0.9234
1.0823−0.9234
= 1.0823−0.9234
≈ 0.512.
 Equity price evolution under CRR model

291.56

269.40

248.92 248.92

230.00 230.00

212.52 212.52

196.36

181.44
 Put option Payoffs

buu

bu 1.08

b bud

bd 37.48

bdd

68.56
 Calculating the price

At t = 0.2, we price like European option

buu = e−0.05×0.1 (0.512 × 0 + 0.488 × 1.08) = 0.5244;

bud = e−0.05×0.1 (0.512 × 1.08 + 0.488 × 37.48) = 18.7492;
bdd = e−0.05×0.1 (0.512 × 37.48 + 0.488 × 68.56) = 52.3845.

At t = 0.1, it is priced like American style

bu = max{1.08, e−0.05×0.1 (0.512 × 0.5244 + 0.488 × 18.7492)}

= max{1.08, 9.3711} = 9.3711;
bd = max{37.48, e−0.05×0.1 (0.512 × 18.7492 + 0.488 × 52.3845)}
= max{37.48, 34.9878} = 37.48.

Thus
b = e−0.05×0.1 (0.512 × 9.3711 + 0.488 × 37.48) = 22.9731.
Barrier options
 Barrier Options

• Barrier option payoffs depend on whether the underlying hits a certain level
before expiration date. The level is called the barrier.

• The barrier options can be knock-in or knock-out.

• A knock-in option is worthless until the underlying touches the barrier price.

• A knock-out option become worthless if exceeds the barrier price.

 Barrier option types

The four main types of barrier options are

• Up-and-out: The spot price starts below the barrier level.

• Down-and-out: The spot price starts above the barrier level.

• Up-and-in: The spot price starts below the barrier level and has to move up for
the option to become worthy.

• Down-and-in: The spot price starts above the barrier level and has to move down
for the option to become worthy.

• You can have a call or put with American, European or Bermudan exercise style.
 European call for an up-and-out barrier option

Table: Barrier option features

Current stock price S 100

Exercise price K 100
Time to maturity T 0.9
Volatility σ 0.30
Risk free rate r 0.05
Barrier B 130
Number of steps n 3
Size of steps ∆t 0.3
Option type up-and-out barrier option

We have u = 1.1786, d = 0.8485 and p̃ = 0.5048.

 Equity price evolution under CRR model

163.72

138.91

117.86 117.86

100 100

84.85 84.85

72

61.09
 Payoff at maturity

63.72

buu

bu 17.86

b bud

bd 0

bdd

We have the price of the barrier option is

b = exp(−0.05 × 0.9)2p̃2 (1 − p̃) × 17.86 = 4.31. The value of the vanilla European
option is

c = exp(−0.05 × 0.9)(p̃3 × 63.72 + 3p̃2 (1 − p̃) × 17.86 + 0 + 0) = 14.30.

Asian options
 Asian Options

• Asian options are a particular type of exotic options that are priced based on the
average price of the underlying instrument.
• The Asian options can be exercised in European or American style.
• Asian options are typically cheaper than European or American options.
• Payoff of Asian call with arithmetic averaging is
 Pn 
i=1 Si
Payoff = max − K,0 .
n
• Payoff of Asian call with geometric averaging is
 !1/n 
 Y n 
Payoff = max Si − K,0 .
 
i=1
 Asian call with arithmetic averaging

Table: Asian option features

Current stock price S 100

Exercise price K 100
Time to maturity T 1
Volatility σ 0.30
Risk free rate r 0.08
Number of steps n 2
Size of steps ∆t 0.5
Option type Asian call

We have u = 1.2363, d = 0.8089 and p̃ = 0.5426.

 Underlying price

152.85
p̃

123.63
p̃
(1 −
p̃)
100 100
p̃
(1
− p̃)
80.89

(1 −
p̃)
65.43
Asian Option Price
 Some References

• Papanicolaou, A. (2017). Introduction to Stochastic Differential Equations (SDEs)

for Finance. arXiv:1504.05309v13

• Hull, J. C. (2011). Options, Futures and Other Derivatives. 8th ed., Prentice Hall.

• Shreve, S. (2005). Stochastic Calculus for Finance I: The Binomial Asset Pricing
Model. Springer.

• Boyle, P. and McDougall, J. (2005). Trading and Pricing Financial Derivatives.

Walter De Gruyter, Berlin.
THANK YOU