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BINOMIAL OPTION PRICING

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Binomial option pricing is a simple but powerful technique that can be used to solve
many complex option-pricing problems. In contrast to the Black-Scholes and other complex
option-pricing models that require solutions to stochastic differential equations, the binomial
option-pricing model (two-state option-pricing model) is mathematically simple. It is based on
the assumption of no arbitrage.

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The assumption of no arbitrage implies that all risk-free investments earn the risk-free
rate of return and no investment opportunities exist that require zero dollars of investment but
yield positive returns. It is the activity of many individuals operating within the context of
financial markets that, in fact, upholds these conditions. The activities of arbitrageurs or
speculators are often maligned in the media, but their activities ensure that our financial markets
work. They ensure that financial assets such as options are priced within a narrow tolerance of
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their theoretical values.

Binomial Option-Pricing Model

Assume that we have a share of stock whose current price is $100/share. During the next
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month, the price of the stock is either going to go up to $110 (up state) or go down to $90 (down
state). No other outcomes are possible over the next month for this stock’s price.

Beginning Value End-of-Month Value

$110
No

$100

$90
Do

This note was prepared by Robert M. Conroy, Associate Professor of Business Administration. It was written as a
basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation.
Copyright © 1990 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights
reserved. To order copies, send an e-mail to [email protected]. No part of this publication may be
reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—
electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School
Foundation. Rev. 4/02.

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Now assume that a call option exists on this stock. The call option has a strike price of
$100 and matures at the end of the month. The value of this call option at the end of the month
will be $10 if the stock price is $110 and 0 if the stock price is $90. The payoff at maturity (one
month from now) for this call option is as follows:

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Beginning Value End-of-Month Value

$10 given a stock price of $100

Call price today

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0 given a stock price of $90

The question is, What should the price of the call option be today?

Consider what happens when we make the following investments in the stock and the call
option. Assume we buy one-half share of stock at $50 (.5 share × $100) and, at the same time,
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we write one call option with a strike price of $100 that matures at the end of the month. Our
investment then is $50 less the current price of the call option. The payoff from this position at
the end of the month would be as follows: on the one hand, if the stock price is $110, our stock
position is worth $55, and we would lose $10 on the option. The return would thus be $45 if the
stock price reached a price of $110. On the other hand, if the stock price should go down to $90,
the value of our stock position would be $45 and the value of our option position would be 0.
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The payoff in this case would also be $45.

Investment Payoff

1/2 share of stock − call option

No

$55 − Max[110 − 100,0] = $45

1/2 share of stock − call option

$50 − call option

1/2 share of stock − call option

$45 − Max[90 − 100,0] = $45
Do

The net effect of taking this particular position on this stock with this payoff structure is
that our payoff is $45 regardless of what happens to the stock price at the end of the month. The
effect of buying 1/2 a unit of the stock and writing a call option was to change a risky position

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into one that is risk-free with a payoff of $45 regardless of the stock price at the end of the
month. Assuming no arbitrage opportunities, an investor who makes this investment should earn
exactly the risk-free rate of return. Thus, we know that the investment, $50 minus the call-option
price, has to be equal to the present value of $45, the payoff, discounted for one month at the
current risk-free rate of return.

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To find the current price of the call option, we need only solve the following equation for
the option price:

$50 - Option price = $45 ⋅ e − RF ⋅T

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Option price = $50 - $45 ⋅ e − RF ⋅T

where RF is the risk-free rate and T is the time to maturity in years. Assuming that the current
risk-free rate of return is 6 percent per annum and a time to maturity of one month (T = .08333),
the current option price of this call option should be $5.22.
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The process used to price the option in this example is exactly the same procedure or
concept used to price all options, whether with the simple binomial-option model or the more
complicated Black-Scholes model. The assumption is that we find and form a risk-free hedge
and then price the option off that risk-free hedge. The key assumption is that the riskless hedge
will be priced in such a way that it earns exactly the risk-free rate of return, which is where
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arbitrageurs come into play. The activity of these individuals—looking for opportunities to
invest in a riskless asset and earn more than the risk-free rate of return—ensures that options are
priced according to the no-arbitrage conditions.

In general, there are two approaches to using the binomial model: the Riskless-Hedge
Approach and the Risk-Neutral Approach. Either approach will yield the same answer, but the
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underlying rationale differs. This note examines both approaches.

Riskless-Hedge Approach

Estimating the riskless hedge

In the example, the hedge ratio, or the number of units of the stock held per call option,
Do

was given. The next step is to demonstrate how we would find the appropriate hedge ratio for a
stock. Assume the following payoff structure for a stock over the next month:

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Beginning Value End-of-Month Value

$95

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$75

$63

In this case, the current stock price is $75, and at the end of the month, the stock will be
either $95 or $63. Suppose we also had a call option with a strike price of $65. The payoff for

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this call option at the end of the month is as follows:

Today Payoff

$30 given a stock price of $95 (Max[95 − 65,0])

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Call price today
Exercise price = $65
0 given a stock price of $63 (Max[63 − 65,0])
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Let H represent the number of units of the stock we should hold. The investment would
be H × $75 − call-option price. If the stock price were $95 at the end of the month, the value of
the call options would be $30. The payoff on our total investment would be H × $95 − $30. If
the stock price at the end of the month were $63, the value of the call option would be 0. The
payoff from the total position on the stock and call option would be H × $63 − 0.
No

Investment Payoff

H shares of stock − call option

H × $95 − Max[95 − 65,0]

H shares of stock − call option

Do

H shares of stock − call option

H × $63 − Max[63 − 65,0]

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We find the appropriate risk-free hedge, H, by setting the payoff in the up state equal to
the payoff in the down state, or

H × $95 − $30 = H × $63 − 0

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$30 − $0
H= = .9375
$95 − $63

Solving for H,1 we find that the payoffs would be exactly the same in each state, if H is
equal to .937. For H = .9375, the payoff in the up state is .9375 × $95 − 30, or $59.0625; in the
down state, the payoff is .9375 × $63 − 0, or $59.0625. Thus, by buying .9375 shares of the

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stock and writing a call option, we have created a riskless hedge with a payoff of $59.0625
regardless of what the stock price is at the end of the month. Assuming no arbitrage
opportunities, the investment—.9375 × $75 − C, where C is the call price—has to be equal to the
present value of the payoff of $59.0625, discounted at the risk-free rate of return. Again,
assuming a risk-free rate of return of 6 percent per annum and a time to maturity of one month (T
= .08333), we find that the call price should be equal to $11.54.
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.9375 × $75 − C = $59.0625 × e − RF ⋅T

$70.3125 − C = $59.0625 × e − .06⋅.08333

C = $70.3125 − $59.0625 × e − .06⋅.08333

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C = $11.54

Self-test example
No

Price an option with a strike price of $80 that matures at the end of one month for a stock
with the end-of-month price distribution shown below:
Do

1
If we look at the estimate of the hedge ratio, it is the ratio of the change in the call-option price to the change in
the stock price. More formally, this ratio is an estimate of the rate of change in the value of the option relative to the
change in the stock price. It measures the change in option value per $1 change in stock price. In a more formal
framework, this is the Delta of the call option. If we hold H (H = Delta) units of stock and write one call option, a
$1 change in the stock price results in an H × $1 increase in the value of our stock position, and this is offset by the
H × $1 change in the value of our option position. Effectively, our total position is “Delta neutral.”

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Beginning Value End-of-Month Value

$95

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$78

$70

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Assuming a risk-free rate of 6 percent per annum, you should get a hedge ratio of .60
and an option price of $5.01.

Using the binomial option-pricing model for more than one period

Suppose we were to take the original example and, instead of having only a single price
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change during the month, we assume that the price change is once every two weeks. You can
see that, by dividing the month into two periods, we wind up with three possible outcomes at the
end of the month.

Now Two Weeks One Month

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$110

$104.88

$100 $100

$94.86
No

$90

Using this pricing dynamic, what would be the price of an option today that matures at
the end of the month and has a strike price of $100?

The approach to solving this problem is really no more difficult than the original one.
The strategy for solving this multiperiod problem is to break it up into a number of simple two-
Do

period models. We work backward!

Consider the branch where the stock price reaches $104.88. From there, during the next
two-week period, the stock price will either increase to $110 or decrease to $100. So we can ask

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at this point, Assuming that the stock price is $104.88, what is the option worth with just two
weeks to go? Once again, the first step is to assume that we buy H units of the stock with two
weeks to go and write one call option. The number of units of the stock we need to buy is the
risk-free hedge. Thus, as before, we determine the payoff structure as follows:

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Investment Payoff

H shares of stock − call option

H × $110 − Max[110 − 100,0]

H share of stock − call option

H × $104.88 – call option

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H shares of stock − call option
H × $100 − Max[100 − 100,0]

We need to choose H such that H × $110 − 10 = H × $100 − 0. The value of H that

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solves this equality is 1.00, and if H = 1.00, the payoff is always $100. Thus, if the stock price is
$104.88 and we buy one unit of the stock and write one call option, our payoff would be $100,
regardless of the stock price at the end of the two-week period. Assuming a risk-free rate of 6
percent per annum and a time to maturity of two weeks (T = .04167), the value of the call option
when the stock price is $104.88 is $5.13.
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1.00 × $104.88 − C = $100.00 × e − RF ⋅T

$104.88 − C = $100.00 × e −.06⋅.04167

C = $104.88 − $100.00 × e −.06⋅.04167

No

C = $5.13

If the stock price at the end of the first two-week period is $94.86, then for the
subsequent two-week period, the stock price is either going to go up to $100 or down to $90. In
either case, the call option will be worthless at the end of that time period, because no one would
ever choose to exercise the call options with a strike price of $100. At the end of the first two
weeks, therefore, if the stock price goes to $94.86, the price of the option would be 0.
Do

We now move back to the first two-week period. The payoff structure for buying the
stock and writing H call options is shown below:

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Investment Payoff

H shares of stock − call option

H × $104.88 − $5.13

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H shares of stock − call option

H shares of stock − call option

H × $94.86 − 0

Note that a new hedge ratio is needed, but the problem is exactly the same as the simple

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problem we faced originally. We first find the value of the H that leads to a riskless payoff. H in
this case would have to be equal to .51198.

H × $104.88 − $ 5.13 = H × $94.86 − 0

$5.13 − $0
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H=
$104.88 − $94.86

H = .51198

In this case, we buy .51198 units of the stock and write one call option. Our payoff
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would be exactly $48.566, regardless of what happened to the stock price.2

.51198 ⋅ $100 - Option price = $48.566 ⋅ e − RF ⋅T

The value of the call options would have to satisfy the following equation. Solving for
the call-option price, we find that it would have to be equal to $2.753.
No

Option price = $51.198 − $48.56 ⋅ e − .06⋅.04167

Option price = $2.753

Do

2
.51198 × $104.88 = $48.566
.51198 × $94.86 = $48.566

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Risk-Neutral Approach

An alternative to the Riskless-Hedge Approach to valuing options using the binomial

model is the Risk-Neutral Approach. The basic argument in the Risk-Neutral Approach is that
because the valuation of options is based on arbitrage and is therefore independent of risk

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preferences, one should be able to value options assuming any set of risk preferences and get the
same answer. Thus, the easier approach is the Risk-Neutral Approach.

In the Riskless-Hedge Approach, the probability of the stock price’s increasing, Pu, or the
probability of the stock price’s decreasing, Pd = 1 − Pu, did not enter into the analysis at all. In
the Risk-Neutral Approach, given a stock-price process (tree), we try to estimate these
probabilities for a risk-neutral individual and then use these risk-neutral probabilities to price a

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call option. For example, we will use the same price process as in the original riskless-hedge
example.

Beginning Value End-of-Month Value

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$95

$75
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$63

If one is risk neutral, then one should be indifferent to risk, and thus the current stock
price would be the expected payoff discounted at the risk-free rate of interest. Assuming a 6
percent risk-free rate, a risk-neutral individual would make the following assessment:
No

[
$75 = Pu ⋅ $95 + (1 − Pu ) ⋅ $63 ⋅ e − RF ⋅T ]
If we solve for Pu:

$75 ⋅ e RF ⋅T − $63
Pu =
$95 − $63
Do

If RF = 6 percent and T = .08333, then Pu = .38675. This is the risk-neutral probability of

the stock price’s increasing to $95 at the end of the month. The probability of its going down to
$63 is 1 − .38675 = .61325. If the stock price goes up to $95, a call option with an exercise price

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of $65 will have a payoff of $30, or 0 if the stock price goes to $63; a risk-neutral individual
would assess a .38657 probability of receiving $30 and a .61325 probability of receiving 0 from
owning the call option. Thus, the risk-neutral value would be as follows:

[
Call-option value = Pu ⋅ $30 + (1 − Pu ) ⋅ $0 ⋅ e −.06⋅.08333 ]

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Call-option value = [.38657 ⋅ $30] ⋅ e −.06⋅.08333

Call-option value = $11.54

This is the same value we got using the Riskless-Hedge Approach. Although the

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approaches appear to be different, they are the same; thus, either approach can be used.

Estimating the Binomial Stock-Price Processes

One of the difficulties encountered in implementing the binomial model is the need to
specify the stock-price process in a binomial tree. While it is not transparent, when we use the
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Black-Scholes model we are assuming a very explicit functional form for the stock price. If we
are willing to make the same assumptions when we are using the binomial model, we can
construct a binomial model of the price process by using the volatility, σ, to estimate up, u, and
down, d, price movements.3 This is done in practice as follows:
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u = eσ Δt
and d = e −σ Δt
,

where σ is annual volatility and Δt is the time between price changes. For example, assume a
current stock price of $55, a volatility of .20 (σ = .20), and a time between price changes of one
month (Δt = .08333). Then u = eσ ⋅ Δt = e.20⋅ .08333 = 1.0594 and d = e −σ ⋅ Δt = e − .20⋅ .08333 = 0.9439,
and the stock-price process over the one-month interval would be as follows:
No
Do

3
For a complete discussion of the assumptions underlying this approach, see R. Rendleman and B. Bartter,
“Two State Option Pricing,” Journal of Finance 34 (1979): 1092-1110.

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Beginning Value End-of-Month Value

$45 × 1.0594 = $47.67

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$45

$45 × .9439 = $42.47

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If we keep the same ending point but let the price change every two weeks (Δt=.04167),
then u = eσ ⋅ Δt = e .20⋅ .04167 = 1.04167 and d = e −σ ⋅ Δt = e − .20⋅ .04167 = 0.96, and the stock-price
process over the one-month interval would be as follows:
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Now Two Weeks One Month

$46.88 × 1.04167 = $48.83

$45 × 1.04167 = $46.88

$46.88 × 0.96000 = $45.00
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$45 $43.20 × 1.04167 = $45.00

$45 × .96 = $43.20

$43.20 × 0.9600 = $41.47

No

We could allow the price change in the example above to change every week (four times
during the month: Δt = 1/52 = .01923) or daily4 (21 times during the month: Δt = 1/252 =
.00397). Thus, given a volatility estimate, we can construct the price process for that security.
Once the price process for the underlying security is determined, it is possible to use the
binomial model to price options on that security.
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4
When we use daily price changes, the general approach is to use trading days during a year or time period and
not calendar days.

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Summary

It may seem surprising that most sophisticated option-pricing models use some form of
the binomial option-pricing model and not the Black-Scholes model, given the latter’s
prominence. The basic approach is to estimate the price process of the underlying asset over the

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maturity of the option and then overlay the option payoffs, given the values of the underlying
asset. Pricing is done on the same basis as presented above. The primary reason that the
binomial model is used is its flexibility as compared with the Black-Scholes model. It can be
used to price a wide variety of options.

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op
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No
Do

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